The Income Investor: two FTSE 100 stocks where dividends count

Income investors naturally prioritise a generous, reliable and growing dividend over capital growth. However, this does not mean that capital returns are irrelevant to them. Indeed, most income investors would baulk at the prospect of their dividend requirements being met while experiencing a substantial reduction in the value of their holdings.

Equally, income investors whose portfolio rises in value while providing a worthwhile income are likely to be relatively content. After all, a larger portfolio in value terms makes the task of obtaining a generous income far easier. It allows an investor to settle for lower-yielding stocks which provide a sufficiently attractive income return, but generally come with less risk than their higher-yielding peers.

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Capital growth can, furthermore, be an indicator of sound company performance. Shares in a firm that has growing profits, is financially sound and has an upbeat outlook are more likely to rise vis-à-vis another company with a downbeat future. And since a strong financial performance that results in growing profits is ultimately a prerequisite for rising dividends, it could be argued that capital growth is a highly important consideration, even for income investors.

Beware of capital gains

Of course, the market value of a company rarely equates to its intrinsic value. Share prices are hugely influenced by investor sentiment, particularly in the short run, which can change frequently and is often misplaced.

For example, investors can become overly optimistic about a company’s future prospects based on its attractive story or upbeat forecasts that may or may not be met. This can lead to a rising share price that does not necessarily equate to a more reliable or faster-growing dividend.

Weak investor sentiment towards a company can also be wholly misplaced. During bull markets, for instance, defensive stocks that pay reliable, growing dividends, and which are a solid fit for income investors, can become relatively unpopular amid a burgeoning investor risk appetite. Such stocks may temporarily deliver disappointing capital returns but continue to offer a sound long-term income investing outlook.

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Separately, a company that delivers strong capital returns may be doing so because it is prioritising growth over dividends. For example, it may be reinvesting a large proportion of its profits to grow in size. Since all companies have a finite amount of profits that can be used for either reinvestment, debt reduction or dividend payments, a growth focus that results in a rising share price can be to the detriment of shareholder payouts and financial stability.

Indeed, a company may be using its profits to make major acquisitions. Or it could even be increasing debt to excessive levels that weaken its financial position. This could make its dividend payments less reliable, while still prompting a rising share price amid upbeat stock market conditions.

A sensible approach

Income investors should, therefore, avoid becoming overly upbeat or downbeat by the level of capital returns in their portfolio. Clearly, it is better to have a portfolio that grows in value. But investors should not automatically assume that this necessarily equates to more certain and faster-growing dividends.

Equally, temporary capital losses should not be viewed as a disaster. The reasons for them should be ascertained and, if they do not affect future dividend prospects and the firm’s outlook remains upbeat, income investors may wish to overlook them. After all, share prices have historically proven to be a typically unreliable predictor of a company’s long-term financial performance.

Dividend investors should also regularly remind themselves of their main goal: to generate a generous, growing and reliable income over the long run. Companies that are able to meet these criteria are likely to be, by nature, financially sound, highly profitable and have an upbeat financial future. Their share prices are therefore likely to gradually rise over the long run, albeit interspersed with temporary periods of volatility along the way.

Tesco

Tesco’s share price has surged 25% since the company was first featured in this column in July last year. Its positive capital return has coincided with an improving outlook for UK consumers. Annual inflation has fallen from 7.9% in June last year to 2% in May this year, which is in line with the Bank of England’s target. This should help eventually resolve the cost-of-living crisis, with average pay rising at a faster rate than inflation for the past 15 months.

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This is excellent news for Tesco (LSE:TSCO)’s financial, and therefore dividend, outlook. It means that shoppers are becoming less price conscious, which provides scope for higher prices and wider margins. This should translate into higher profits and greater scope to increase shareholder payouts. Indeed, the firm’s dividend payments increased by 11% in its latest financial year. This is vastly above inflation and means investors in the stock have benefitted from an increase in their purchasing power.

The company’s latest trading update showed that it continues to perform relatively well. Like-for-like sales in the first quarter of the year rose by 3.4%, with the firm confirming its previous guidance for the full year. Its annual results showed that it remains financially sound, with net interest costs covered five times by operating profits, while its decision to sell its banking operations to Barclays and engage in a further share buyback seem logical. They allow it to focus on its core operations and take advantage of a relatively low share price.

Tesco’s shares currently trade on a price/earnings (PE) ratio of around 13. This suggests there is further capital growth potential on offer. Perhaps more importantly, its dividend yield of 3.9% remains relatively attractive, with it being 20 basis points higher than that of the FTSE 100 index. Given its solid financial position, improving operating environment and sound strategy, the stock continues to offer a favourable income investing outlook for the long run.

British American Tobacco

While Tesco’s share price has risen since the company was first featured in this column, British American Tobacco (LSE:BATS)’s market valuation has declined. Its shares have fallen by around 9% since it was featured in the very first Income Investor column in May last year. However, when an income return of 15% over the past 14 months is factored in, the stock’s total return amounts to a rather more encouraging 6%.

The company raised dividends by 2% in its latest financial year. When combined with its share price fall, this means that the stock now yields roughly 9.5%. This is around 2.6 times higher than the FTSE 100’s yield.

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Although a falling share price is undoubtedly disappointing, the company’s long-term risk/reward opportunity remains favourable. Certainly, it faces several challenges that could hold back its financial performance.

For example, a difficult operating environment in the US, continued regulatory changes and evolving consumer tastes could be detrimental to its near-term profitability. But with the firm making progress in shifting its focus towards reduced-risk products such as e-cigarettes, as well as having a solid position in tobacco markets that offer the prospect of a strong and reliable cash flow, it is well placed to deliver further dividend growth.

British American Tobacco’s shares currently trade on a PE ratio of just 6.6. This suggests they offer a wide margin of safety, as well as recovery potential. With a net debt-to-equity ratio of 66%, the firm has a solid financial position that reduces overall risk. When its high yield and dividend growth potential are factored in, the stock’s long-term income investing appeal remains attractive.

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