10 dividend growth stocks for the next five years

In a market in which worries over dividend sustainability and dividend growth have grown, it is reassuring that high-quality companies with significant headroom for sustainable dividend growth remain available.

Our list of companies has been selected from the top decile of a multi-factor screen. The screened universe is the FTSE 350 index based on criteria you can find outlined here. The screen has been devised based on both dividend sustainability and the potential for long-term growth.

For dividend sustainability, the key characteristic is free cash flow cover. Free cash flow is the spare cash flow available to shareholders at the end of each year - after all expenses, interest, tax and capital investment required to both sustain and grow the dividend.

A business whose dividend is not covered by free cash flow will be using increased borrowings to fund some of its dividend. This is clearly not sustainable over the long term.

Such companies may end up under-investing to cover today's dividend, which will lower the longer-term dividend growth potential, or they may need to cut their dividend.

Some companies in the market, such as the oil majors, are generating negligible or negative free cash flow currently. This means that all of the dividend is being paid through increased borrowings.

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The larger the free cash flow headroom on a dividend, the more of a safety buffer the company has in more difficult times. All companies go through periods of adversity - whether it be due to a downturn in the overall economy, the industry the company operates in, or for some stock-specific reason.

But a company with high free cash flow cover on its dividend is much better placed to be able to continuing paying a steadily growing dividend through thick and thin.

Free cash flow cover is the first building block of dividend growth. It gives a company plenty of room to increase its dividend steadily.

Over the longer term, growth in free cash flow is key. Businesses that routinely generate healthy cash-flow tend to consistently return cash to you as a shareholder - whether as ordinary dividends, special dividends or share buy-backs. They are able to fund their future growth internally.

Conversely, businesses that struggle to generate free cash flow have to look externally for growth capital - either via rights issues or increasing debt positions. Issuing shares to fund a dividend payment is like robbing Peter to pay Peter.

The shareholder provides capital to the business, and is then given it back in the form of a dividend. The taxman and underwriters benefit from this process, but not the shareholder.

Companies with a high and consistent return on capital are particularly well placed. They are able to grow sustainably at a high rate thanks to the compounding of re-invested earnings at a high rate of return.

Albert Einstein was attributed with the quote compound interest is the eighth wonder of the world: he who understands it, earns it. He who doesn't pays it.

Current market thoughts: Funding the future

A sluggish global economy since the 2008 crisis means companies are finding organic growth harder to come by than in the pre-crisis world. With this backdrop, a range of other 'techniques' are being utilised to please shareholders unsatisfied with these lower growth rates, such as buy-backs and growth through acquisition.

In many cases, operational and capital investment programmes have been reduced to help fund these initiatives. This dynamic is perhaps most obvious amongst the oil majors at present, but these themes are present in many businesses today.

Just because organic revenue growth is harder to come by, doesn't mean it shouldn't be pursued. Arguably, with a diminished tailwind from the global economy, businesses should be even more committed to organic investment for their long-term futures.

So why aren't companies investing? Organic investment decisions are most influenced by management's confidence in the future. Uncertainties (whether due to a difficult economic backdrop globally, volatile commodity markets, a forthcoming referendum, etc) make companies more reluctant to spend money when the future benefits feel more uncertain.

Furthermore, and in my view most importantly, organic expansion has no positive benefit for this year's current financial results. In fact, it has a negative effect, hitting both current earnings and free cash flow. This is in stark contrast to acquisitions and share buy-backs in the current environment.

With the cost of debt so low, and cash sitting on corporate balance sheets earning next to nothing, almost any acquisition or share buy-back at any valuation multiple will be immediately accretive to earnings. As a result, the short-term minded executive will be tempted to buy growth rather than drive it internally.

We, the investment community, play a role here. When investors talk about valuations, they almost always refer to the current year's price/earnings ratio, or the current year's free cash flow yield.

Analysts feverishly move earnings forecasts for the coming year (or quarter) up and down, shares change hands at a rapid rate, and trading statements that lead to a 5% increase or decrease in this year's earnings often leads to a rise or fall of 5% (or more) in a company's share price.

But current earnings (or next year's, or the one after's for that matter) are just the starting point on a long journey of what might be anything from wonderful value creation to a miserable tale of long-term value destruction.

In owning any share you have a lifetime's entitlement to a fraction of that company's free cash flow stream, and the (hopefully growing) dividend stream this cash generation funds. For a business to grow this cash-flow sustainably over the long term, it needs to make an ongoing commitment to growth investment.

This should be the case even for the asset-light companies that we focus on. Though reinvestment requirements are smaller relative to the average company, these businesses still need to reinvest in their futures. The really nice thing, however, is that they tend to be able to do this while having cash left over to pay healthy dividends too.

Reckitt benckiser

Reckitt Benckiser is a well-diversified portfolio of global health, hygiene and homecare brands selling repeat-purchase products. Brands include Dettol, Finish.

Long-term potential in emerging markets is excellent, and now represents more than half of the company's sales.

Burberry

Burberry is of the UK's strongest international fashion brands with plenty of international growth potential, and a strong online presence.

Sage

Sage is the global market leader in the provision of enterprise software for small and medium-sized businesses. It sells to more than 6 million customers in 160 countries.

Its products, such as accountancy software, become embedded in the day-to-day running of a business, creating a consistent revenue stream from subscription and support contracts.

This revenue is growing steadily and now makes up almost three-quarters of sales. The company routinely converts profit to cash flow and, as well as the historic growth in ordinary dividends, special dividends have been a feature in the past.

Spectris

Spectris makes devices and systems that help other manufacturers and producers to become more efficient. It is a global leader in its niche market, with plenty of potential for growth over coming years.

PZ Cussons

PZ Cussons is a mid-sized consumer-branded goods company with a brand portfolio including Imperial Leather, Carex and Cussons Baby. Good potential for growth in emerging markets long term, particularly thanks to market leading positions in Africa and Indonesia.

Euromoney

Euromoney is a business-to-business media company, providing research, data and events primarily to the financial and commodities sector.

Brands include Euromoney, Institutional Investor and BCA Research. Subscription-based products, many of which are digital, make up more than 50% of revenue.

WS Atkins

WS Atkins is a market leading UK engineering consultancy, with strong positions overseas including a US, Middle Eastern and South East Asian business. Strong balance sheet and very high free cash flow cover supports a progressive dividend policy.

Rotork

One of the highest-quality mid-cap franchises in the UK market, Rotork sells mission-critical products in industries that require the control of liquids and fluids (such as power, water, oil and renewables).

Its highly cash generative business model and strong balance sheet equip it well for paying sustainable dividends, and special dividends have been a feature for investors on top of this ordinary payment.

Diploma

Not on the face of it a terribly exciting stock. A specialist distribution business, the group operates in three main areas - life sciences, industrial seals and electronic controls.

Diploma is the business you turn to when you need anything from a replacement part for your dump truck's hydraulic cylinder to a chemical reagent for a diagnostic blood test. However, these businesses, while dull, operate in very niche markets which Diploma has come to dominate over the years.

Paypoint

A payment technology company, helping consumers pay utility bills, top up mobile bills, pay tax, buy parking tickets and send parcels. Paypoint's network of yellow boxes spans more than 28,000 retailers across the UK.

The business has limited capital requirements and its strong balance sheet and free cash flow supports a healthy dividend yield. Management takes a pragmatic attitude to returning excess cash to shareholders and, along with growth in ordinary dividends, special dividends have been a feature in the past.

Approach taken in deriving the list

We have selected companies from the top decile of quantitative screen described above, where we think growth prospects over the next five years should be positive. These are companies that we research and follow from a qualitative perspective.

This is an indicative list and does not represent the Evenlode portfolio (although seven of the stocks in the list are held currently and all are in our investable universe).

The three stocks that are currently not in the portfolio (Burberry, Euromoney and Diploma) are not included due to our view on valuation (we have a discounted cash flow approach to valuation, but for the purposes of this screen we have used a simple 2%+ dividend yield filter).

I would also point out that quantitative screens are not a substitute for hard work! They can point you in interesting directions as an investor, and potentially throw up interesting ideas. But in our view ongoing qualitative research is a key part of a long-term investment approach.

Data from screening sources can also be of questionable value and treatment of different items can be inconsistent. This is another reason why they should only be used as a first cut. We go direct to the source (i.e. company accounts) for our data and make sure the data is treated consistently in our financial models.

Hugh Yarrow and Ben Peters are managers of the Evenlode Income fund.