Income Investor: lower-yielding stocks with dividend appeal

Some income investors immediately rule out any stock that does not offer a significantly higher yield than the wider index. For example, the FTSE 100 currently yields 3.7%. This means that some income seekers may determine there is little point in purchasing a company with a yield below that figure.

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Other dividend investors, meanwhile, may feel that a yield of 4% or even 5% is the minimum required to compensate them for the additional risks of purchasing direct equities versus a tracker fund. After all, the latter provides diversification benefits compared with individual equity holdings because it contains all of the companies in the index.

Dividend growth

However, ruling out vast swathes of the FTSE 100 just because they do not match, or even beat, the index’s income return may be rather short-sighted. For starters, it means the pool of potential purchases narrows dramatically. For example, only considering stocks with a yield in excess of that of the wider index means 63% of the FTSE 100 is currently out of bounds to income investors. And those individuals who demand a 4% or even 5% yield would presently have the choice of just 33 and 19 stocks, respectively.

Furthermore, they would potentially miss out on companies that, while offering a relatively modest yield at present, have strong dividend growth potential. Over the long run, a fast pace of growth in shareholder payouts can make a surprisingly large impact on an investor’s income return.

For example, a stock that yields 3% now but grows its dividends by 10% per year will yield 7.8% within a decade. Conversely, a stock that yields 5% today but only grows its shareholder payouts by 2% per year will yield 6.1% by the end of the same time period. Both examples assume no change in share price.

Risk considerations

In addition, lacklustre share price performance may be the reason for higher yields in some cases. For instance, a firm may be struggling to generate profit growth due to a tough operating environment. Or it may have a weak balance sheet that has prompted downbeat investor sentiment. Investors who buy such companies simply because of their relatively high yield may fail to obtain their expected income return as the company is forced to cut, or ‘rebase’, its dividends in response to financial difficulties.

Moreover, the diversification benefits of owning a FTSE 100 tracker fund are sometimes overestimated. Certainly, an index fund is spread across 100 or so different companies in the case of the UK’s large-cap index. But with the index’s five largest members accounting for 32% of its total market capitalisation at present, it still suffers from concentration risk, with its biggest constituents having a disproportionately large impact on its performance and income prospects.

Focusing on quality

Clearly, some higher-yielding stocks are likely to be worth purchasing. In some cases, they offer the prospect of a generous and growing income return. Equally, though, investors may wish to avoid simply dismissing those stocks with yields that are not particularly high.

Indeed, it may be prudent to initially consider the quality of a company in terms of its financial position, competitive advantage and future prospects, rather than solely focusing on its yield. This could provide guidance on how reliable its dividend may prove to be, as well as how quickly it can grow given the firm’s future earnings prospects. After all, dividends must ultimately be funded by profits over the long run.

Furthermore, companies that have well-covered dividends may be more likely to raise shareholder payouts at a faster pace than profit growth. And firms that are transitioning from their growth phase to a more mature era may be more likely to raise dividends at a brisk pace as they begin to lack sufficiently attractive reinvestment opportunities.

A tough period

Global consumer goods company Reckitt Benckiser Group (LSE:RKT) currently has a dividend yield of 3.9%. This is just 0.3 percentage points higher than the FTSE 100 index’s yield, which may naturally prompt some income-seeking investors to rule it out as a potential purchase. This is especially the case because the company is currently experiencing a challenging period.

Its latest trading update, for example, showed that like-for-like sales rose by just 0.4% in the first nine months of the year. This was largely due to a weak performance from its Nutrition segment, with its 11.6% decline in like-for-like sales more than offsetting growth in the firm’s Health and Hygiene divisions. The segment’s weak performance was prompted by damage to a warehouse caused by the Mount Vernon tornado, as well as a rebasing of volumes after temporary supply issues were experienced by a key competitor.

Sound fundamentals

Despite a somewhat disappointing recent performance, the company remains on track to meet financial guidance for the full year. Crucially, its dividends are well covered by profits at 1.7 times, which suggests there is scope for them to further rise following a 5% increase in the first half of the current year. Meanwhile, the firm’s net debt-to-equity ratio of 84% and net interest cover in excess of 19 highlight its sound financial position. This suggests it is capable of overcoming future economic or industry-related challenges.

Moreover, the company has a strong competitive position. Its broad range of brands, which include well-known names such as Dettol, Nurofen and Gaviscon, command a high degree of customer loyalty. This equates to strong pricing power that provides scope for profit, as well as dividend, growth over the long run. And with the firm reporting in its latest quarterly update that it grew market share in two of its three divisions, its competitive position appears to be sound.

An improving outlook

The company is in the midst of implementing a revised strategy that could act as a positive catalyst on its financial performance. Notably, it plans to focus on its strongest brands and potentially dispose of some of its weaker performers. It is also seeking to become more efficient through a reduction in costs, which could have a positive impact on its bottom line.

Clearly, the firm’s operating environment has been challenging in the recent past due to a cost-of-living crisis in some of its key markets. With inflation across major developed economies having fallen dramatically over the past couple of years, and interest rate cuts now starting to be implemented, the outlook for consumer spending could improve. This may prompt higher demand for its products, as well as provide greater scope for higher margins, that bolster its dividend growth prospects.

Income potential

With Reckitt Benckiser’s shares having fallen by 11% since the start of the year, they now trade on a price/earnings ratio of 15.1. While this is by no means cheap, and the firm’s uncertain near-term operating outlook as well as ongoing litigation risk could prompt further share price volatility in the short run, its solid fundamentals and sound competitive position mean that it appears to offer good value for money on a long-term view.

While its yield of 3.9% may naturally put off some investors, given it is only marginally higher than the wider index’s yield, the company’s dividend growth prospects suggest that it offers income investing potential.

Moreover, its shareholder payouts are well covered by profits and, given the potential for interest rate cuts as well as modest inflation across developed markets, the firm appears to offer a favourable risk/reward opportunity.

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