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One dividend knockout I’d buy instead of the FTSE 100

Billionaire Warren Buffett’s oft-repeated advice to US investors is to avoid stock-picking and active funds and put money regularly into an S&P 500 index-tracker. The equivalent for UK investors would probably be a FTSE 100 index tracker.

I agree completely with Mr Buffett’s view that a passive fund with low costs is likely to outperform a more expensive actively-managed fund. But I also believe that investors who build a diversified portfolio of income stocks still have the opportunity to beat the market.

Not great value

One of the main attractions of owning a slice of the FTSE 100 is that it should provide a reliable long-term dividend income. But the collective dividend payout of these mega-cap companies is starting to look a little stretched to me.

According to the latest published figures, the FTSE 100 offers a dividend yield of 3.9%. However, this yield is only covered 1.02 times by earnings. In other words, these companies are collectively paying out almost all of their earnings as dividends.

Of course, this isn’t true for all companies. One factor behind this low level of cover is that some of the index’s largest dividend stocks — such as BP and Vodafone — have been paying dividends that are not covered by earnings.

The risk here is that earnings will fail to recover quickly enough at some of these big companies. If that happens, one or more of them could be forced into a dividend cut. I’m not sure how likely this is. But with the FTSE 100 also trading on a P/E of 25, I don’t see much value here. I’d rather focus my attention elsewhere.

A 6% yield?

Investing in dividend stocks requires a balancing act between dividend yield and dividend growth. I prefer to focus on stocks with a yield of between 3% and 6%, and a growth rate slightly ahead of inflation.

One stock that fits this description is Isle of Man telecoms operator Manx Telecom (LSE: MANX). The group’s shares currently offer a forecast yield of almost 6%. This dividend has grown by an average of 4.9% per year since the group’s flotation in 2014.

You might expect a telecoms operator on a small island to have limited growth potential. But Manx serves an affluent business and residential market, and also offers a number of high-margin specialist services to customers further afield. Sales have grown from £69m in 2011 to £80.8m in 2016.

Manx shares fell by 4% this morning, after the group said its pre-tax profit fell by 17% to £5.2m during the first half of this year. However, much of this reduction is the result of a two-year transformation programme. The aim of this is to cut costs, upgrade IT technology and improve the group’s customer offering.

Stripping out these costs and focusing on cashflow gives a more stable picture. The group’s underlying operating cash flow was £10.2m during the period, compared to £10.1m last year.

Today’s results confirmed that management expects full-year results to be in line with current forecasts. That puts the stock on a forecast P/E of 13.1 with a prospective yield of 6%. In my view, Manx Telecom could be a decent long-term buy for income investors.

Five income stocks I'd buy

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended BP and Manx Telecom. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.