Interactive Investor

How to build the best dividend stock portfolio

3rd December 2015 12:01

Danielle Levy from interactive investor

Miner Glencore's decision earlier this autumn to scrap its final dividend serves as a stark reminder that investors can't always rely on FTSE 100 names to deliver the income they require.

Income-seeking investors currently face a host of challenges - not least because dividend cover for third-quarter 2015 has fallen to a six-year low across the UK stockmarket, according to Capita's latest UK Dividend Monitor. This measures how comfortably a company can pay dividends out of profit.

The fall has largely been attributed to earnings weakness among the oil majors and miners as a result of falling commodities prices. These stocks form a big component of the FTSE 100 index and many investors rely on the dividends paid out by them.

A panel of expert fund managers has compiled a sample portfolio of nine stocks for dividend income, which you can read here.

Looking for the best dividends

It goes to show that investing for income is as much about avoiding the losers as picking the winners. Getting the balance right, between companies that pay out a healthy dividend and those that are capable of growing their dividends, is also essential.

Also, avoiding stocks with declining earnings or the potential to issue profit warnings is a must, as both can lead to dividend cuts and share price falls.

In spite of the challenges, investors who back the right income stocks can be rewarded handsomely. By investing with this bias you are able to benefit from the compounding effect of reinvesting the returns made on your underlying portfolio, maximising the potential to boost gains even further.

So how can income-seeking investors strike the right balance within their portfolios? Sadly there are no hard-and-fast rules when it comes to creating a portfolio of dividend stocks, but a good starting point is to set out a clear goal or income target from the outset.

"You have to be clear about what you are trying to achieve. It is important to have a set of rules and then to stick to them," explains Carl Stick, who manages the Rathbone Income fund.

At all times, Stick focuses on the fact that investors are relying on the income generated from his fund. For this reason, he is not willing to hold stocks that don't pay a dividend. In his view, income stocks fall into three categories.

First, the so-called "compounders". These are viewed as high-quality businesses with a good track record of paying and growing dividends, and are known for reinvesting capital back into the business for future growth.

Stick allocates around 40% of his portfolio to compounders, highlighting Restaurant Group, which owns Frankie & Benny's, as an example.

Cash cows

The only problem is that a company's ability to consistently grow its dividend rarely goes unnoticed by other investors, making it harder to buy in at an attractive price.

"The second type of business is the 'cash cow', which generates high returns but is unable to reinvest [because it is already highly leveraged]," Stick explains. He counts tobacco, utility and telecom stocks in this category.

They offer a high dividend yield, which indicates how much a company pays out each year relative to its share price. However, dividend growth prospects are hampered because these businesses are unable to reinvest capital to drive future growth and may need to consider increasing their borrowings to do so.

Cyclical businesses, including turnaround stories, fall into the fund manager's third category. This includes commodities-related businesses (including miners such as BHP Billiton and Rio Tinto), banks and even pharmaceutical stocks such as GlaxoSmithKline.

Two types of risk

Stick identifies two types of risk faced by income investors. There is so-called "business risk" associated with buying stocks in the third category, but Stick argues this can be lessened if you believe the market has overreacted to negative news and you buy when the share price looks cheap.

The other key risk is "price risk", where you can pay too much for a stock that is deemed high quality by the market. Balancing the two risks is crucial, in his opinion.

Dividend growth

Gervais Williams, manager of the CF Miton UK Multi Cap Income fund, only holds stocks that offer the prospect of dividend growth. "We believe that one of the key drivers of returns is the growth of the dividend income from the portfolio, so we tend to let the non-growers leave the portfolio," he explains.

He cites Lok'n Store, which provides self-storage space, as an example. It has grown its dividend by more than 25% over the past three years.

Williams' sentiments are echoed by Thomas Moore, manager of the Standard Life Investments UK Equity Income Unconstrained fund. He is steering clear of oil and gas stocks, banks with significant legacy issues and pharma GlaxoSmithKline, because he says they don't offer dividend growth potential.

"BP and HSBC are busy shrinking their businesses to fit their existing dividend policy. This feels the wrong way round. My approach is to focus purely on stocks with the potential to grow dividends," Moore explains.

He is positive about a number of banks that are not weighed down by legacy issues, such as Close Brothers and Virgin Money. Close Brothers survived the financial crisis unscathed and has emerged even stronger, carving out a niche as a lender to small and medium-sized businesses.

"It has a very successful track record of growing its dividend, and has never cut its dividend. This is a very different situation from some of the mainstream high street lenders," he adds.

Should investors consider investing in stocks that don't currently pay out a dividend but could do in the future? Some fund managers say this is fine, as long as there is a clear indication from the management team that it will happen soon. It is also worth exploring whether the balance sheet and the latest earnings figures support the promise.

For example, Williams held gift-packaging manufacturer International Greetings before it paid out a dividend.

"The company did not pay a dividend during the period when it was investing over £10 million in productivity improvements in its plants, but now this investment is starting to lead to a sizeable cash payback," he says.

Richard Colwell, who manages Threadneedle UK Equity Income, currently has logistics provider Wincanton in the portfolio. It doesn't pay a dividend, but he expects it will start to pay one soon.

"Over the last three years the share price has more than tripled from the lows, despite not paying a dividend," Colwell observes. The rest of his portfolio is made up of what he describes as "engine room" compounders and contrarian recovery stocks.

Dividend traps

One of the biggest challenges income investors face is avoiding "dividend traps", where earnings growth falls but the stock's dividend yield remains elevated.

Unless this trend reverses, it will typically result in a dividend cut, which is bad news for any income investor.

However, Peter Webb, manager of the Elite Webb Smaller Companies Income & Growth fund, notes that investors should not necessarily fear high yields because this doesn't always indicate that a dividend is under pressure.

It can suggest that the company is mature and less capital-intensive, in an unpopular sector or simply misunderstood. "Lots of mature businesses distribute cash and have low dividend cover because they have no need for it," he says.

Nevertheless, if, after looking at a prospective company's recent trading updates you have any doubts about earnings growth potential, the balance sheet or dividend cover, Webb recommends avoiding that stock.

Standard Life Investments' Moore adds, finally, that big isn't always beautiful when it comes to dividend safety. "Why do investors get stuck in dividend traps?", he asks.

"These are often the largest stocks in the UK market, so there can be a misplaced sense of safety among investors who flock into them."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.