Share prices have been paddling sideways thanks to the stock market correction in 2022 and the near-correction in 2023. The recent Santa rally helped kick things up a notch, though. If surging shares are a sign of things to come, then now might be a great chance to pick up cheap income stocks.
The FTSE 350 now boasts 61 stocks offering a 6% dividend yield or higher. These inflated yields may not last too long if the markets rally in 2024. Income hunters may want to lock in those big yields before it’s too late.
But a 6% yield is just one part of the story. I want to buy companies, not stocks. By picking high-quality businesses, I’d hope to see total returns closer to double-digits over the long run.
The holy grail is a slowly increasing dividend. An AJ Bell study examined FTSE 100 dividend stocks and found firms with less than 10 years of dividend increases returned 5.2% to investors. Those with 10 years or more? 12.6%.
Bumping it up
A few extra per cent sounds attractive but hardly does justice to the end result. Over a 30-year period, a 5.2% return turns £10k into £46k. A 12.6% return, on the other hand, turns it into £351k.
Of course, I could point at the past’s big winners like Diageo, BAE Systems and Croda all day. But what we really want to do as investors is sniff out tomorrow’s most rewarding investments.
One important factor in judging the future of dividends is debt. A company creaking under a bloated balance sheet will have to stump up big financing costs – money that can’t be rerouted to shareholders.
Worse still, a CEO might bump up dividends to keep shareholders happy even if the firm ends up overleveraged. Debt problems were one reason for the 2018 demise of construction firm Carillion. Shareholders were wiped out.
But when looking at the titans of the FTSE 100, it’s easy to get overwhelmed by massive 10 or 11-digit numbers. But a £10bn debt pile isn’t necessarily bad, and may even be desirable.
Starting point
Utility stocks often have huge amounts of debt and pay most incoming cash flows as dividends, but such consistent income makes racking up large debts to pay capital investment par for the course.
The debt-to-equity ratio is a way of sidestepping the big numbers. This metric takes the total debt and divides it by the total shareholder equity. As a rule of thumb, when the ratio is below one then debt levels are safe and above two and they may be risky.
The London Stock Exchange is home to thousands of businesses, so picking a handful to invest in is never going to be easy. But I’d say whittling them down to those with manageable debt levels and a dividend with room to grow is a better starting point than most.
