The Income Investor: why cash is not king and three dividend stocks to own

A run of 12 interest rate rises has lured some investors into cash, but this strategy is not completely risk free, and dividend stocks still offer a better long-term investing outlook than cash savings accounts, writes Robert Stephens in his first column for interactive investor.

Last week’s interest rate rise could tempt some income investors to hold cash instead of shares. After all, the Bank of England’s 0.25 percentage point rise to 4.5%, its highest since 2008, means that easy-access savings accounts now offer rates up to 3.7%. Savers willing to lock up their cash for a year can obtain a rate of 4.9%, more than the FTSE 100 index yield of 3.9%.

Since inflation remains significantly above the Bank of England’s 2% target, it’s possible that further interest rate rises lie ahead. Indeed, the ‘Old Lady of Threadneedle Street’ also upgraded its growth forecasts for the UK economy so that it now expects GDP growth, rather than a recession, in the current calendar year. Only when inflation begins a genuine and sustained decline will rates start to come down.

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Despite its improving prospects, the economy’s outlook remains highly uncertain. Challenging trading conditions for stock market incumbents could mean their share prices come under a degree of pressure, with interest rate changes and equity market performance having historically enjoyed an inverse relationship. Cash, meanwhile, offers no risk of loss subject to savings being within the financial services compensation scheme limits.

The appeal of dividend stocks

However, income investors should not give up on dividend stocks in favour of cash.

While your initial cash sum is safe, owning cash is not completely risk free. UK inflation remains above every savings rate on the market, so holding too much cash for too long erodes the value of your money.

There are no guarantees how long rates will remain this high – if market pundits are right, borrowing costs might begin to fall either later this year or early 2024.

Many savings accounts, especially those with eye-catching rates, also have restrictions, either on how much or how little you can invest, how often you can access your money, or they may include an introductory bonus.

Although the stock market’s yield is somewhat underwhelming compared with savings accounts, a wide range of shares currently offer dividend yields that are significantly more appealing. That means, it’s still possible to obtain a substantially higher income return from a diverse portfolio of shares than it is from any savings account.

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Income stocks also offer the potential for dividend growth over the long run. Certainly, dividend growth rates in some, but not all, sectors have been rather subdued during the current period of monetary policy tightening that has acted as a drag on economic growth. But forecasters expect the UK, and world, economy to perform better over the coming years. For example, the global economy is forecast to grow by 3% next year versus 2.8% this year, according to the International Monetary Fund (IMF). The UK economy is tipped to grow by 1% next year versus a 0.3% contraction in 2023.

Dividend growth is particularly crucial right now, given double-digit inflation. Income received from cash savings accounts is gradually becoming worth less over time. But a stock that raises dividends at a relatively fast pace could realistically provide an income stream that grows in real terms over the coming years. Since above-target inflation may prove to be somewhat stickier than the Bank of England currently expects, positive real-terms dividend growth could prove to be a very useful ally for income-seeking investors.

Investing in shares, rather than holding cash, also offers scope for capital gains. Although the short-term performance of the stock market can prove to be highly volatile and somewhat random, its long-term track record highlights its capacity to significantly outperform cash returns. For example, the FTSE 250 index has risen by roughly a third over the past decade despite its lacklustre performance in recent years. Cash, meanwhile, offers zero scope for capital growth.

Source: Refinitiv as at 11 May 2023. Bond prices from Morningstar are bond ETFs as at 30 April 2023. LIBOR is interest rate banks lend money to one another (3 month LIBOR). Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER).

An exceptionally high dividend yield

Holding part of a portfolio as cash can prove to be a logical move. It offers a degree of security and provides flexibility to capitalise on temporarily undervalued assets, but relying on it for an income is unlikely to be a prudent long-term plan. Instead, purchasing a diverse portfolio of income stocks that offer attractive yields, dividend growth prospects and capital growth potential is likely to be a far more rewarding strategy.

For example, financial services company Legal & General Group (LSE:LGEN) currently yields more than twice the FTSE 100 index’s income return. It has raised dividends per share at an annualised rate of 9.7% over the past decade so that its shares now yield around 8.8%.

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While its historical rate of dividend growth is slightly behind the current rate of inflation, it is significantly higher than the 2.4% average rate of inflation over the past decade. With inflation likely to fall as rising rates have their desired effect, the company’s dividend could realistically grow at a positive real-terms rate in future.

The firm’s latest annual results show it is well placed to capitalise on growth opportunities across a wide range of areas including investment management, infrastructure investment and pensions. Although its longstanding CEO recently announced that he will soon retire, L&G’s low valuation suggests it offers a wide margin of safety. Indeed, its forecast price-to-earnings (PE) ratio of just 7.1 – similar to Aviva (LSE:AV.) and below its own 10-year average PE of 11.5 - suggests that there is significant scope for an upward rerating to its shares over the long run.

A rapid pace of dividend growth

Meanwhile, paper-based packaging company Smith (DS) (LSE:SMDS)’s dividend has grown rapidly in spite of an uncertain global economic environment. It raised dividends by 24% in its latest financial year and subsequently increased them by 25% in the first half of its current year. With dividend cover of around two times and a forecast yield of 5.9%, the company offers a potent mix of a relatively attractive income return today and the prospect of inflation-beating dividend growth in the coming years.

The company’s operating profit margin increased by 1.5 percentage points in the first half of the current financial year to reach 9.7%, despite rising costs prompted by rampant inflation. This shows it has a strong competitive position, since it was able to pass on higher costs to consumers, while it expects further margin improvement of 0.3-2.3 percentage points over the medium term.

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Alongside the prospect of higher revenue resulting from an improving economic outlook, and ongoing structural changes across numerous industries that are shifting towards environmentally friendly paper-based packaging, this could contribute to growing profits and higher dividends. A PE of a modest 7.3 suggests the company’s shares offer good value for money.

Inflation-beating dividend prospects

British American Tobacco (LSE:BATS)’s shares are also priced at an attractive level. They trade on a PE of just 7, having fallen by 29% in the past five years amid weak investor sentiment. This has contributed to the stock’s dividend yield currently standing at 9%.

Although tighter regulations towards the industry and changing consumer tastes are proving to be disruptive to the tobacco sector, BAT is making encouraging progress in new product areas. For example, its non-combustible products, such as e-cigarettes and heated tobacco, now account for 15% of total revenue and are expected to deliver their maiden profits next year.

Alongside the relative consistency and robust cash flow provided by its legacy cigarette portfolio, this could act as a catalyst for the company’s dividend growth prospects. And with nicotine-related products being relatively price inelastic, BAT was able to increase its operating profit margin by 1.5 percentage points to 44.9% last year. This bodes well for prospects in the current era of stubbornly high inflation and increases its appeal as part of a diverse portfolio of income stocks.

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