National Grid (LSE: NG) is one of the most popular dividend stocks in the UK, and it’s easy to see why. The company owns the majority of the country’s electricity distribution infrastructure, which gives it a steady, predictable income stream and makes it an extremely defensive investment.
As the firm’s contracts with customers usually span several years, management can set dividend policy safe in the knowledge they know roughly how much money the company will be making in the near term — that’s the theory anyway.
Cracks starting to show
However, as I highlighted in my last article on the company, National Grid’s deteriorating balance sheet could become problematic.
Net debt has increased from £23bn to £26bn between 2013 and 2018 as the group’s net profit has stagnated. Meanwhile, management has been steadily growing National Grid’s annual dividend payout. Deteriorating earnings and a rising payout means dividend cover has fallen from 1.5 to 1.2 since 2013.
As I’ve said before, it’s difficult to tell if, or when, this trend will become a problem for National Grid’s dividend, but it’s something I don’t want to be exposed to. At the same time, there are some signs regulators are looking to clamp down, which only adds further uncertainty to the mix.
After considering all of the above, even though National Grid’s 5.5% dividend yield might look attractive, I don’t think it’s worth taking the risk. If the company suddenly decides to cut its dividend, the shares could lurch lower, inflicting severe losses on income investors.
So, I’m a seller of the National Grid share price. One company I think could replace this utility giant in your portfolio is Alpha FX (LSE: AFX).
Selling one of the UK’s largest utility businesses to buy a small-cap growth stock might not seem a sensible idea at first, but I firmly believe Alpha will outperform National Grid in the years ahead.
Alpha is a foreign currency broker, which helps its clients manage the impact of currency volatility. This might not seem like a particularly defensive business, but it’s a booming market. Globalisation has helped foreign exchange trading become one of the largest financial markets in the world with more than $5trn trading activity going on daily.
At present, Alpha makes up a tiny sliver of this market. Over the past five years, the company has proven itself growing revenues from just £3m to £23.5m. What’s more, unlike so many other small-cap growth stocks, the company has been profitable virtually from the very beginning.
It reported a net profit of £740k in 2014, the first year for which we have accounts and net profit hit £7.8m last year. Alpha’s management believes it’s “barely scratching the surface” of the group’s potential, and I completely agree.
What I’m particularly excited about here is the dividend potential. At the time of its IPO in 2017, Alpha told shareholders it would pay out 30% of underlying profits after tax each financial year. Following a record performance in 2018, today management has declared a total dividend of 6.5p for 2018, up 33% year-on-year.
This gives a dividend yield of only 1.1% at present, but considering Alpha’s historical growth and £35m net cash balance, what the payout lacks in size it more than makes up for in quality.
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The Motley Fool UK has no position in any of the shares mentioned. 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.