The Income Investor: don’t underestimate the value of dividend growth

The income investing landscape has changed dramatically over the past two years. In October 2021, Bank Rate stood at just 0.1%. Today, it is 5.25%. As a result, it is now relatively straightforward to obtain a generous yield from mainstream assets.

The FTSE 100, for example, yields just under 4%, partly because of interest rate rises weighing on investor confidence in the stock market. Some investors may, therefore, believe that managing an income-focused portfolio has become rather easy.

• Invest with ii: Top UK Shares | How to Start Trading Stocks | Open a Trading Account

This, though, is wholly incorrect. There is far more to income investing than merely obtaining a high yield today. A portfolio must generate a sufficient level of income to sustain an individual’s lifestyle over the long run. This essentially means that the amount of income it generates increases in line with, or ideally beats, inflation.

The importance of dividend growth

Indeed, dividend growth is at least as, if not more, important than dividend yield when it comes to income investing. There is little point in enjoying a very high level of income today only for it to decline on an after-inflation basis over the coming years. Such a situation would prompt a deterioration in living standards that, over time, could even cause financial difficulty.

For example, income investors facing a choice between two stocks – one yielding 5% and the other 3% – will almost certainly gravitate to the former. However, the company with a 5% yield may fail to produce any dividend growth in future because of weak financial performance that has already been factored into its stock market valuation. Conversely, the lower-yielding share may enjoy strong profit growth that, when combined with a low payout ratio, allows it to pay a larger dividend in future.

• The four FTSE 100 income stars returning big money in October
• Richard Beddard: this £2bn company is a winner and good value

Assuming a very achievable 5% annual rise in dividends over a 20-year period, a stock yielding 3% today will ultimately have a yield on its purchase price of around 8%. Therefore, it could prove to be a worthwhile purchase for income-seeking investors relative to a 5%-yielding share that offers little, if any, prospect of future dividend growth.

Unearthing dividend growth stocks

Many FTSE 100 stocks currently offer generous yields, but have somewhat questionable dividend growth potential. Clearly, higher profits are usually required to fund greater dividends. Therefore, income investors should seek to purchase companies that have the potential to either grow sales, or improve profit margins over the coming years. This can be undertaken by focusing on areas such as their competitive advantage and the outlook for the sector in which they operate.

Although a solid track record of dividend growth does not necessarily mean that shareholder payouts will continue to rise, it nevertheless bodes well for a firm’s future income growth prospects. Likewise, a company that has a modest dividend payout ratio, which is calculated by dividing shareholder payouts by net profits, may be in a stronger position to afford more generous payouts in future.

Indeed, a company’s dividend policy can also provide guidance on its future income growth prospects. Management may seek to cover dividends with net profit by a lower amount than at present, for instance, which suggests that an increase in shareholder payouts will take place.

Source: Refinitiv as at midday 9 October 2023. Bond yields are distribution yields of selected Royal London active bond funds (31 August 2023), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 5 October. LIBOR is interest rate that banks lend money to one another (3-month GBP LIBOR as at 6 October). Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 9 October.

Opportunities for dividend growth

Of course, with inflation still standing at more than three times the Bank of England’s 2% target, and not expected to fall to below that level for around two years, inflation-beating dividend growth is likely to prove challenging in the short run. Ongoing high inflation, though, makes it even more important to focus on dividend growth, rather than solely on dividend yield, to maintain the spending power of any income produced by an investment portfolio.

• Stockwatch: are 10% yields in this sector an invitation or warning?
• This share is a magnet for income investors with a long-term view

Several FTSE 100 stocks have excellent track records of raising dividends at a brisk pace. Yet their payout ratios remain relatively modest, which signifies they have scope to increase shareholder payouts at the same, or even greater, pace than profit growth.

Furthermore, their capacity to pay higher dividends is likely to increase as the prospects for the UK, and world economy strengthen over the long run. This is set to create operating conditions that are more conducive to improving financial performance.

BAE Systems

FTSE 100 aerospace and defence company BAE Systems (LSE:BA.) has a bright future from a dividend growth perspective. The company is set to benefit from rising global defence spending in response to elevated geopolitical risks that have largely been prompted by Russia’s invasion of Ukraine. Indeed, eleven NATO members are forecast to meet the annual military spending target of 2% of GDP this year. Only seven members managed to reach the target last year.

The company’s solid financial position, as evidenced by a net gearing ratio of 33%, means it has the capacity to make acquisitions to further grow profits. For instance, it recently announced the purchase of Ball Aerospace, which is set to deliver annual revenue growth of 10%, alongside margin improvements, over the next five years.

Although BAE currently has a dividend yield of just 2.7%, it has a solid track record of raising shareholder payouts. Over the past three years, for instance, dividends per share have risen at an annualised rate of 5.2%. When coupled with operating conditions that are likely to be more upbeat than those experienced over recent years, it would be unsurprising for future dividend growth to equal, or even exceed, past increases.

With dividends covered around twice by profits, the company’s shareholder payouts are very affordable. In terms of reliability, they have increased for 19 consecutive years. With defence spending being linked to GDP growth, and the world economy’s performance set to improve as interest rate rises abate and borrowing costs eventually decline, the outlook for BAE’s dividend growth rate is highly favourable.

Diageo

Alcoholic beverages company Diageo (LSE:DGE) also offers the prospect of fast-paced dividend growth over the long run. The company has an excellent track record of raising dividends, increasing payouts at an annualised rate of 5.8% over the past decade. This is significantly above the average inflation rate of 2.4% over the same period, and suggests its investors will continue to enjoy a positive real-terms rise in income over the coming years.

Despite its brisk rise in dividends over recent years, the company’s shareholder payouts were covered more than twice by profits in its latest financial year. When combined with the size and scale of the business, as well as the relatively defensive characteristics of the alcoholic beverages industry, this suggests that its dividend reliability is high.

• ii view: Guinness owner Diageo in optimistic mood
• Share Sleuth: the big ballsy contrarian decision I’ve made

In terms of dividend growth, the company’s wide range of highly desirable brands means it enjoys a significant amount of customer loyalty. In turn, it can raise prices to improve profit margins. It also has a solid financial position which has allowed it to pursue a ‘premiumisation’ strategy that has included several acquisitions. Further progress in this area has the potential to catalyse profitability and provide scope for rising shareholder payouts.

As with BAE, Diageo’s dividend yield of 2.6% lacks appeal on a standalone basis. Indeed, many income investors may already have dismissed both stocks due to the significantly greater yields on offer elsewhere in the FTSE 100.

However, with the capacity to raise dividends at a relatively fast pace over the long run, both stocks are worthwhile holdings in an income portfolio. The importance of their ability to deliver real-terms dividend growth in the coming years should not be underestimated.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.