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Why I’m in love with these hated dividend stocks

Photo: Pearson plc. Fair use.

History shows that the best time to buy a stock is often when its future is at its bleakest. That’s because the market already anticipates a tough time for the business, so its valuation is likely to be super-low. As such, it could benefit from an upward re-rating, while its yield may be higher than it would normally have been. With that in mind, here are two unpopular stocks which could prove to be top-notch income plays.

Uncertain outlook

The future for educational specialist Pearson (LSE: PSON) is highly uncertain. Its most recent update showed an unexpected slowdown in sales and profitability which is due to cause a fall in its bottom line of 20% in 2016, followed by a decline of 10% in 2017. Even in 2018, Pearson’s earnings are expected to flatline, which means that its current level of dividend may prove to be unaffordable. After all, it has a payout ratio of over 90%.

However, given the company’s share price fall in recent months, even a near-halving in its dividend would leave it on a yield of 4.1%. This is still around 40bps higher than the wider index and shows that Pearson could prove to be a worthy income stock in the long run.

Certainly, there are changes to be made to the business and there are no guarantees that dividends will only be halved. However, such a fall would leave the company on a payout ratio of around 53%, which seems to be sustainable. Furthermore, since it has a price-to-earnings (P/E) ratio of 12.9 even after factoring in this year’s potential fall in earnings, it has a relatively wide margin of safety. This shows that as well as a high yield, Pearson could produce high capital gains in the long term.

Turnaround potential

Also unpopular among investors at the present time is support services business, Capita (LSE: CPI). It trades on a P/E ratio of only nine, since its earnings are due to decline by around 7% this year. Part of the problem facing the business is the difficult outlook for the outsourcing sector. After a number of years of strong growth, outsourcing is now arguably less popular than it once was and competition within the industry is picking up.

Despite this, Capita could have a bright future. It has a relatively sound balance sheet and its turnaround plan seems to be logical. It could cause the company to record a return to growth as early as 2018. It is forecast to report a rise in earnings of 4% in that year, which could show investors that its long-term outlook is relatively bright.

With Capita having a yield of 6.2% from a dividend which is covered twice by profit, its income outlook is impressive. Its shares may remain in the doldrums in the short run as its business performance continues to disappoint, but in the long run it seems to have stunning total return potential.

Top income stock

Despite the potential of Capita and Pearson as income stocks, there's another company that could be an even better buy. In fact it's been named as A Top Income Share From The Motley Fool.

The company in question could make a real impact on your income prospects in 2017 and beyond. Its potent mix of a growing dividend and impressive yield could increase your income returns right now.

Click here to find out all about it - doing so is completely free and comes without any obligation.

Peter Stephens owns shares of Capita Group. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.