Dividend stocks can be a tremendous source of passive income. However, finding companies that can maintain and expand shareholder payouts for decades can be quite tricky. After all, of the thousands of companies listed on the London Stock Exchange, only a small minority go on to become dividend aristocrats.
Finding aristocrats of the future
Buying and holding a company that can continuously raise its dividend each year can lead to impressive wealth generation. A perfect example of this would be billionaire investor Warren Buffett’s holding in Coca-Cola. After 60+ years of hiking payouts, the ‘Oracle of Omaha’ is now earning a yield in excess of 50% on his original cost basis!
Of course, finding the next Coca-Cola is not that easy. All it takes is one external factor to disrupt operations, like the Covid-19 pandemic, and a multi-year streak can come to an end.
Therefore, to minimise this risk, I believe investors should hunt cash-generative businesses. Specifically, companies that remain essential even in the direst of economic circumstances. And two cheap income stocks that have come across my radar this month are Greencoat UK Wind (LSE:UKW) and LondonMetric Property (LSE:LMP).
Capitalising on energy and real estate
It’s no secret that electricity demand is rising, especially renewable energy, in the face of worsening climate change. A similar story is true for commercial warehouse real estate. As more consumers shift their shopping habits online, the demand for well-positioned logistics facilities climbs, particularly in urban areas.
So far, these trends have proven powerful tailwinds for Greencoat and LondonMetric. Both firms have achieved modest but consistent cash flow expansion, funding an ever-increasing dividend. And as of today, both have increased shareholder payouts for eight consecutive years.
Personally, I think it’s highly unlikely the need for clean electricity and prime-located warehouses will disappear any time soon. That’s why I’m confident both firms can continue on their current trajectory, rewarding patient investors along the way. But, like with any investment, they’re not risk-free.
Debt can be problematic
Both Greencoat and LondonMetric are registered as REITs. This is a special type of enterprise that’s immune to corporation tax. However, the downside is that 90% of net underlying earnings must be returned to shareholders via a dividend.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
That may sound like a great deal for investors on paper. But the reality creates problems. With virtually no earnings retained, REITs, no matter how profitable, are dependent on external financing, usually debt. As per the latest figures, LondonMetric is sitting on around £1bn of debt and equivalent obligations, while Greencoat has just under £1.4bn.
The cash-generating nature of these enterprises means that neither appears to be in financial distress. But with rising interest rates, the years of cheap financing are over. And with further hikes potentially coming, the pressure on earnings and, in turn, dividends are mounting.
Having said that, the impressive track record of both firms gives me confidence they can navigate a higher interest rate environment. That’s why I believe the risk is worth taking and why I’ve already added both to my personal income portfolio.