Last year the Brandes Institute published a study analysing public market data as far back as 1926 to evaluate the impact dividend income had on total returns. The main finding of the study was this… over all rolling 20-year periods between 1926 and 2014, dividend income accounted for more than 60% of US equity returns. In other words, if you want to achieve the best returns, you should always have a basket of income stocks in your portfolio.
Due to their defensive nature, most investors turn to National Grid (LSE: NG), SSE (LSE: SSE) and Centrica (LSE: CNA) for the income component of their portfolios but are these the best income stocks around?
Rising competition
The biggest issue facing National Grid, SSE and Centrica is regulatory risk. These three companies are heavily regulated and can only charge customers a set amount for the provision of their services, according to guidelines established by regulators. This means that while these companies have a stable income stream, the amount of money they can return to investors is restricted to a certain degree.
Indeed, Centrica and SSE have both been forced to cut or re-base dividend payouts during the past few years as falling profits have put pressure on cash flows.
Alongside the issue of political risk, these companies are also facing a threat from a rising number of competitors who are starting to eat away at their market share. For an industry that’s historically been dominated by one or two main players, this is a highly significant development.
National Grid, on the other hand, is in a much more defensive position. While the company still has to comply with regulatory demands, it has virtually no competitors, and it’s unlikely the company will ever have to deal with any.
What’s more, National Grid deals mainly with other businesses, not consumers, on long-term contracts giving the company visibility over future cash flows. All in all, National Grid displays all the essential characteristics of Warren Buffett’s “business moat”.
Are the dividends safe?
Centrica and SSE are facing some political and competition risks but for the time being their dividends seem to be sustainable and covered by earnings per share.
After recent declines, SSE’s shares currently support a dividend yield of 6.5%, and the payout is covered 1.3 times by earnings per share, leaving some wiggle room for the company to manoeuvre if revenues fall.
Centrica cut its dividend payout last year, but even after this cut the company’s shares still support a dividend yield of 5.7%, and the payout is covered approximately one-and-a-half times by earnings per share. Assuming Centrica’s troubles are now over, and the company can return to growth, the payout looks safe for the time being.
In my opinion, National Grid has the most reliable dividend of these three utilities. The company’s shares currently support a dividend yield of 4.4%, and the payout is covered one-and-a-half times by earnings per share. And National Grid’s “business moat” should ensure that the company continues to generate enough cash flow to maintain this payout for the long-term.
