The Income Investor: two dividend growth stocks with attractive yields

When most investors think of dividend stocks, they are likely to picture stable companies with defensive characteristics that offer high yields. While there are many such dividend shares in existence that provide a generous and reliable income return for investors, in reality dividend stocks come in all shapes and sizes.

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For example, some dividend shares offer a lower yield and a less reliable income stream in return for the prospect of fast-paced dividend growth. Often, they are cyclical companies that can generate a rapid rise in earnings in an economic environment that is conducive to growth. They may be deemed worthwhile purchases by investors who can accept greater fluctuations in their income return, as well as the potential for relatively large temporary paper losses along the way.

Clearly, such companies may be unsuitable for income-seeking investors with a relatively low risk tolerance. However, for their peers with a higher capacity to tolerate risk, now could be a worthwhile time to buy cyclical stocks that offer strong long-term dividend growth potential while they trade at low prices and offer surprisingly high yields.

Bargain prices

Indeed, UK-listed shares are exceptionally cheap at present. Even though the FTSE 250 index, which is far less internationally focused than the FTSE 100 index, has risen by 11% in just over two months, valuations remain at a low ebb compared with other major indexes. Investors appear to be concerned about prospects for the UK economy, where inflation remains relatively high, economic growth is weak and the prospect of interest rate cuts is somewhat more distant than in the US or eurozone.

However, on a long-term view, investing in bargain mid-cap UK income stocks could prove to be a highly profitable move. Inflation has declined rapidly over recent months and is expected to fall below 2% within two years, according to the Bank of England. This suggests that interest rates are set to decline substantially over the coming years, which is likely to have a positive impact on the economy’s growth rate. In turn, this could equate to fast-paced earnings and dividend growth for UK-focused companies over the coming years.

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Moreover, many FTSE 250-listed stocks generate a large proportion of their earnings from outside the UK. Their prices may currently be marked down due to the unpopularity of UK-listed stocks, thereby providing investors with access to global income stocks at bargain prices.

Dividend growth potential

Of course, the yields on offer among cyclical FTSE 250 stocks are typically lower than those of more defensive and stable companies in the FTSE 100 index. However, the strong dividend growth prospects of mid-cap shares could more than make up for their lower initial yields over the long run.

For instance, a company that currently yields 4% and grows its shareholder payouts by 15% per annum over a 10-year period would generate a total income return of around 81%. It would end the period with a dividend yield of around 14%, assuming no change in its share price. Conversely, a company that yields 6% today but grows its dividends per share by just 5% over the next decade would produce a total income return of around 75%. Its yield would end the period at 9%, assuming no changes to its share price.

Fundamental strength

Clearly, no company raises its dividends in a linear fashion. There are inevitably economic, industry and company-related challenges that can negatively impact profitability and shareholder payouts over an extended time horizon. But the above example serves to show that for long-term investors, dividend growth rates could be just as, if not more, important than yields. And when the capital return potential of dirt cheap and fast-growing cyclical shares is factored in, their total return could prove to be significantly greater than that of more defensive and stable income stocks.

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As ever, income investors should ensure that any purchases they make are fundamentally sound. Dividends should be amply covered by profits, which reduces the chances of them being cut and increases the prospect of their growth as earnings rise. Likewise, companies that have solid balance sheets and sustainable competitive advantages are more likely to overcome challenging economic conditions to benefit from faster paced GDP growth as inflation falls and interest rate cuts move ever closer.

Source: Refinitiv as at 3 January 2024. Bond yields are distribution yields of selected Royal London active bond funds (30 November 2023), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 1 January. LIBOR is interest rate that banks lend money to one another (3 month GBP LIBOR as at 2 January). Best accounts by moneyfactscompare.co.ukrefer to Annual Equivalent Rate (AER) as at 3 January.

Morgan Advanced Materials

FTSE 250-listed Morgan Advanced Materials (LSE:MGAM) is an example of a cyclical stock with long-term dividend growth potential. The company manufactures advanced carbon and ceramic materials that have a variety of applications, including in wind farms and aeroplane engines. It currently yields around 4.3% following a 12% share price fall over the past year.

The firm’s recent financial performance has been somewhat mixed. It experienced a cyber security incident in January last year that negatively affected its operations and contributed to a 38% fall in earnings per share in the first half of the year. However, its latest trading update showed it is recovering from the incident and has been able to more than offset high inflation via price rises. It has also experienced robust demand across several key markets and appears to be well placed to benefit from an improving global economic outlook due to its diverse geographical exposure.

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Dividends per share were covered 2.6 times by earnings in its most recent financial year. Having slashed dividends during the pandemic, they have trebled on a per share basis over the past three years. While a similarly high rate of growth seems unlikely in the short run as the firm fully recovers from its cyber security incident, its long-term dividend growth potential appears to be high.

In the meantime, the company's net gearing ratio of 65% suggests it has a sufficiently sound financial position to overcome short-term economic uncertainty. And with its shares trading on a forward price/earnings (PE) ratio of 11.5, the firm offers good value for money as the economy’s improving outlook catalyses its financial performance.

Inchcape

Automotive distributor Inchcape (LSE:INCH) also offers attractive long-term income investing potential. The company’s shares have fallen by 14% over the past year and currently yield around 4%.

Dividends per share have risen fourfold since they were reduced during the pandemic – they increased by 28% in the most recent financial year. They were covered 2.5 times by earnings, with the firm aiming to maintain a similar level of cover in future. This suggests that any increase in profits will be passed through to shareholders in the form of higher payouts.

The company’s recent update showed that it is on track to meet financial guidance for the full year, with its revenue growth of 35% being boosted by acquisitions. Since the company trades in a fragmented global market, further M&A opportunities are likely to become available. And with asset prices being relatively low due to the global economy’s uncertain near-term outlook, the firm’s acquisition strategy appears to be sound.

Inchcape’s net gearing ratio of 69% shows that its balance sheet is sufficiently strong to withstand short-term economic uncertainty. It also has exposure to a wide range of geographies to further reduce overall risk. Meanwhile, its forward PE ratio of less than 9 highlights the wide margin of safety on offer to investors and its potential to deliver capital gains.

As with Morgan Advanced Materials, Inchcape does not fit the typical “stable and defensive” dividend stock mould. Its financial performance is closely linked to the economy’s prospects. Given that a period of interest rate cuts is likely to be ahead, both companies’ attractive yields, dividend growth potential and low valuations mean they are appealing income shares on a long-term view.

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