10 top income stocks for risk averse dividend investors

Big companies with high dividend yields are naturally popular with income-focused investors. But they don't always turn out to be the safe, reliable investments that their owners had hoped for.

This year we've seen dividend cuts at some of the market's highest yielding stocks, including TalkTalk, Carillion, Admiral and Provident Financial. These companies saw their share prices savaged after slashing their payout, landing a double hit for their weary shareholders.

On these occasions, share prices and dividend payouts recover at very different and unpredictable rates, and some don't recover at all. It shows just how important it is to try and avoid the risk of a dreaded high yield trap - but how?

One answer is to take inspiration from a successful approach used by a handful of investment firms, such as Societe Generale, Fidelity and Investec. It's called Quality Income, and as the name suggests it zeroes in on high yields in good quality stocks.

What does financial quality look like?

The simple idea behind Quality Income is that financially strong firms don't often have to slash their dividend payouts. For Investec, for example, 'economic moats' are the definition of quality. Their strategy looks for above average yields in firms that are growing their dividends and have sustainable businesses protected by competitive advantages.

By comparison, Fidelity's Quality Income approach ranks high yield firms according to a string of measures that focus on cash flow, profitability and low debt. Again, they target firms with a record of growing dividends that are well covered by earnings.

Finally, Societe Generale, which was an architect of Quality Income strategies, looks for high (but not excessive) yields in firms with strong balance sheet health and low bankruptcy risk. It's a strategy that has worked impressively well since it was launched as an index in 2012.

A focus on dividend quality

For individual investors, there is a lot that can be learned from these approaches. A strategy tracked by Stockopedia that models Quality Income rules has managed a 14% return over the past year - not including dividends, which would have pushed the performance higher.

Put simply, the strategy looks for stocks with a yield of more than 4% (but less than 15%) in companies with a minimum market cap of £800 million. Each firm should pass at least seven of the nine checks in the Piotroski F-Score (I looked closely at this checklist in a recent article for Interactive Investor).

The F-Score looks for improving trends in a company's profitability, debt, liquidity, share dilution and operating efficiency. The strategy also checks for any risk that a company might go bust by using another accounting checklist called the Altman Z-Score. Financial stocks are excluded from the results.

To get a broader view of each company's quality, I've also included Stockopedia's Quality Rank. This scores and ranks each company against a range of 'quality' measures and brings them together in a single number - the higher the better.

This strategy picks up a broad range of stocks on forecast yields for the next financial year of more than 4.7%. As demanded by the rules, these firms all have strong balance sheet health trends, as measured by the Piotroski F-Score. And for the most part they also have decent Quality Rank scores.

While the strategy pairs high yield and high quality, it still manages to pick up some of the most popular names among income investors. Topping the list with yields of more than 7% are the transport group Stagecoach, housebuilder Taylor Wimpey and the energy giant Centrica. The rest are all big-name dividend shares ranging from SSE, BP and Rio Tinto to Royal Mail, Dixons Carphone and Marks & Spencer.

Comfort for risk averse investors

There has been a string of dividend cuts among high profile, high yield stocks this year. Usually these have coincided with reports of poor financial performance. Put together, these events have left investors nursing the pain of reduced dividend payouts and tumbling share prices.

While it's impossible to fully isolate a portfolio from the misery of a dividend cut, there are strategies that can offer some protection. Quality Income brings together above-average yields with robust financial quality to shine a spotlight on companies that are less likely to hit trouble. For risk-averse dividend investors, it's a strategy that could offer some extra comfort.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson 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.

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook"

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.