How to find safer dividends with a quality income strategy

The prospect of a Greek default and possible exit from the euro have spoiled the party for European shares this year. After a strong start, indices across the Continent and the UK are showing signs of jitters as a result of the uncertainty. So it's understandable that investors may now be wondering which shares offer a potentially better bet in a period of volatility. One option would be to consider a dividend strategy called Quality Income.

Dividend stocks are traditionally popular with investors who prefer a stable income over capital growth. There are strategies to suit all tastes - whether you're after long-term payout growth or the very highest forecast yields.

But while high yields can be seductive, evidence shows that stocks on the very highest yields often disappoint investors. In fact, a very high yield can be a sign that the market has lost confidence in a company. It may be that the business is in trouble or the dividend is expected to be cut. Either way, the share price is driven down and, as a consequence, the yield on the share increases.

We've seen notable examples of this over the past year in supermarket shares like Tesco and Sainsbury's. Having previously offered useful yields of around 5%, both companies have had to cut their dividend payouts because of pressure on earnings.

To counter the risk of high yield "traps", Quality Income looks for large, high quality companies in strong financial shape, which offer good - but not excessive - yields. It's an approach that has strong support among quantitative finance professionals. Investment bank Societe Generale runs its own quality income index, and it's also used in the FTSE RAFI Equity Income index, created by Research Affiliates.

For regular investors, screening for companies with reasonable yields, sound balance sheet health and good business economics is simple with the help of a few quality checklists.

The first is to use a nine-point accounting-based test created by American finance professor Joseph Piotroski. His F-Score specifically looks for improving trends in a company's profitability, debt, liquidity, share dilution and operating efficiency.

With financial strength covered, Quality Income also checks for any risk that a company might go bust. Here it uses another accounting checklist called the Altman Z-Score. Devised by professor Edward Altman, this test combines five ratios that aim to show how closely a company resembles others that have filed for bankruptcy.

With these checklists at hand, Stockopedia created a Quality Income screen for Interactive Investor. Companies had to pass at least seven of Piotroski's nine checks and show low risk of bankruptcy. They also needed to be on a forecast yield for next year of at least 4%.

We also included Stockopedia's broad-based assessment of a firm's quality, called the QualityRank, which scores and ranks all companies in the market according to their financial and business strength - from zero (low) to 100 (high).

The median forecast yield on offer is 4.5%. Leading the list in terms of quality is housebuilder Persimmon and fashion retailer Next. Both of these companies are highly regarded as strong, profitable businesses that are generous in rewarding shareholders.

Interestingly, Persimmon isn't the only housebuilder here, with Taylor Wimpey and Galliford Try offering yields of 5.5% and 4.5% respectively.

So-called "sin stocks", which can tug at the ethical concerns of investors, are often among the highest yielding shares in the market. On this list they include tobacco firm Imperial Tobacco, on a forecast yield of 4.7%, and bookmaker Ladbrokes, which offers the highest yield, at 5.8%.

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With the benefit of hindsight, this portfolio of Quality Income stocks would have produced a 21% return over the past year, compared to a broadly flat performance by the FTSE 100.

While high yields are an obvious attraction to dividend hunters, it's important to recognise when an eye-catching yield is actually masking potential problems in a business. In periods of volatility, troubled shares can be the first to suffer from waning investor confidence. With a quality income approach there is a stronger likelihood that companies can withstand economic pressures and jittery markets, and keep their dividends intact.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ed Page Croft of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

About the author

Ben Hobson is Strategies Editor at Stockopedia.com. His background is in business analysis and journalism.

Ben writes regularly on investment strategy performance and screening ideas for  Stockopedia. He is the author of several ebooks including "How to Make Money in Value Stocks"