Many investors need a regular and increasing income from their shares but also like the companies they invest in to show predictable growth, so that the share price rises and delivers a decent capital gain over the years.
This means identifying companies with a long record of increasing dividends, along with steadily growing profits, earnings per share (EPS) and stock prices. This clearly excludes companies with the highest dividend yields but only very low growth.
With interest rates at their highest since 2008, investors are looking for stocks where the dividend yield and EPS annual growth rate are jointly well above the rate of interest that can be earned from easy-access savings accounts (currently just over 4%).
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The Barclays Equity Gilt Study shows that between 1899 and 2019, equities beat cash for 76% of the fiveyear periods.
We expect the type of company identified in this article to do better than that. Five years is a sensible choice, since it is the shortest time horizon over which it is wise to invest in shares.
For example, if a company’s share price rose by 10% each year for five years it would be worth 60% more than at the start of the half-decade.
So even if the dividend yield is only 2% each year, total returns would easily beat any savings account. If you had put £1,000 into a savings account paying 4%, you would receive income of £200 over the five years.
But £1,000 invested in the stock would deliver a total of £728, comprising a capital gain of £595 plus total dividends of £133 (the dividend rises from 2% of £1,100 at the end of the first year to 2% of £1,595 for the last).
Both cash and shares are tax-free if they are in an Isa. If you are prepared to take the extra risk of shares over a cash deposit, then shares, in this example, give you more than three-and-a-half times the return from cash deposits.
Four key requirements
When searching for a company with both a good long term share-price performance and consistent dividend yield, you need to focus on four key factors.
These are, firstly, a record of profitable growth (revenue, profit and EPS growing predictably); and, secondly, a record of steadily increasing dividends with good dividend cover.
That means the dividend is a modest proportion of net profit – less than 50% is best, so dividend cover is over two times.
Thirdly, the company needs net cash or modest debt to ensure it avoids getting into financial difficulties when interest rates rise; fourthly, it has a “moat” – an enduring competitive advantage that deters potential rivals from entering its market.
Strong brands and patents are examples of moats. We will give examples of companies satisfying these criteria from several different sectors such as biopharmaceuticals, defence and aerospace, engineering, food, beverages, distributors and business services.
Most of the examples given below pay dividends giving yields of at least 2%. But we also include two companies with records of profitable growth and rising dividends where the current yield is less than 2% but is likely to rise above 2% in a few years, given the company’s dividend growth record.
Top picks in seven major sectors
The first example is Merck (NYSE: MRK), with a forward dividend yield of 2.76%; the payout has risen every year for more than the last ten years.
Merck has a record of growth with revenue up by 40% to $59.3bn since 2018, and EPS up by 145% to $5.73 over the same period.
Net debt is a comfortable 42% of operating profit and dividend cover is more than two times. Merck has a wide moat formed of patents and economies of scale, and boasts the successful cancer drug Keytruda, with 2022 sales of $21bn.
Keytruda illustrates Merck’s strong position in the emerging area of immuno-oncology. Merck is also strong in vaccines and active in diabetes and other diseases.
Merck invests 22.9% of sales in research and development (R&D) to develop its pipeline of new drugs, and the productivity of its R&D has improved in recent years.
This high investment in R&D should ensure it has new, patented drugs to replace existing ones as they come off patent. Merck’s share price has jumped by 80% over the past five years.
In the defence and aerospace sector we pick Lockheed Martin (NYSE: LMT), the world’s largest defence contractor, which makes fighter aircraft (including the advanced F-35), Sikorsky helicopters, missiles and space systems.
It has a wide moat based on intangible assets, decades-long product cycles, and the prohibitive cost to a client of switching to a competitor’s products.
The dividend yield is 2.63% and the shares are up by 41% over the past five years. Revenue has increased by 23% to $66bn since 2018, while operating profit is up by 15% to $8.4bn.
The dividend has been raised every year for the past 20 years, and has doubled since 2015.
In the engineering sector our choice is Spirax-Sarco (LSE: SPX), which has a long record of profitable growth, providing customers with industrial and commercial steam systems, control equipment, electric thermal products and pumps.
It has a wide moat based on intangible assets, switching costs and close relationships with customers.
While the forward dividend yield is only 1.42%, the dividend has been steadily raised each year for at least ten years. It doubled from 76p in 2017 to 152p in 2022.
If this pattern were repeated over the next six years, the yield on an investment made now would rise to 2.84%. Revenue has climbed by 41.5% to £1.6bn since 2018.
Operating profit has jumped by 45% to £347m over the same period. The share price has gained 59% over the past half-decade.
McDonald’s looks tasty
In the food sector there is McDonald’s (NYSE: MCD), which boasts a wide moat and a steadily rising dividend that currently gives a 2.07% yield. The shares are up by 89% over the past five years.
Another example in food is Archer-Daniels-Midland (NYSE: ADM), one of the world’s major processors of oil seed, corn, wheat and other agricultural products.
It also transports, stores and sells crops worldwide and has an animal-ingredients business.
ADM has a forward dividend yield of 2.26% and the shares are up by 74% over the past five years. Sales grew by 58% to $102bn between 2018 and 2022, with operating profit up by 109% to $4.2bn over the same period.
In the beverages sector our example is Coca-Cola (NYSE: KO), which has a wide moat based on its famous brand and sheer scale; a forward dividend yield of 3%; and shares that have increased in value by 46% over the past five years.
The dividend has increased every year for more than 20 years. Revenue expanded by 35% to $43bn between 2018 and 2022, with operating profit up by 29% to $12bn over the same period. We have two examples from the distribution sector.
The first is Diploma (LSE: DPLM), which supplies specialised technical products and services to a range of industries through its three divisions of controls, seals (for mobile machinery and fluid power) and life sciences.
Diploma’s current yield is 1.85% but the dividend has more than doubled to 53p in five years, with the share price up by 135% over the same period.
Revenue more than doubled (£485m to £1.01bn) from 2018 to 2022, while operating profit almost doubled to £144m in the same time span.
Were the dividend to double over the next four years, too, the yield for an investor buying the shares now at 3,120p would rise from the current 1.85% to 3.7%.
The second example from distributors is Bunzl (LSE: BNZL), which provides customers in 30 countries with thousands of items, including cleaning products, disposable cutlery and personal protective equipment (the majority for the food-service sector).
Bunzl’s forward dividend yield is 2.25%, and the dividend has been raised every year for at least a decade. The dividend has almost doubled to 62.7p in the last ten years and the shares are up by 25% over the past five years.
Sales have grown by 33% to £12bn since 2018, with operating profit increasing by 51% over the same period. Relx (LSE: REL) is a promising stock from the business-services sector.
It is a diversified data-analytics specialist, with clients in scientific, medical, and legal fields. Its forward dividend yield is 2.14% and the shares have climbed by 54% over the past five years.
Relx has a comfortable operating profit margin (operating profits as a percentage of sales) of 27% and maintains steady growth of sales, profits and dividends.
The dividend has been raised every year for at least ten years and has more than doubled since 2014.
The importance of diversification
I chose seven sectors because of the importance of diversifying investments to reduce the effect that a problem in one sector can have on overall returns.
For example, I remember an acquaintance of mine praising his big investment in Lloyds Bank some years ago.
It was giving him an excellent dividend income. The payout was 23p in 2007-2008, so with the share price at 270p in February 2008, the yield was a satisfying 8.6%.
But then came the financial crisis and Lloyds paid no dividend at all from October 2008 to May 2015.
The dividend for 2015-2016 was only 1.25p, rising to 2.4p in 2022-2023, with the current share price around 46p. It was therefore unwise to put a large investment into one company in the banking sector despite its apparent safety and attractive yield before 2008.
Contrast this with, for example, Coca-Cola, which increased its quarterly dividend from $0.17 in 2007 to $0.21 in 2009 and $0.46 in 2023.
Merck’s dividend, meanwhile, was unchanged from 2007 to 2009 and has since almost doubled. The key point about diversification is to have companies in varying sectors that are likely to respond differently to problems in the economy.
For example, banking is likely to behave very differently to pharmaceuticals if growth hits the buffers; the same applies to the drinks and engineering industries.
Use the examples given above to help you choose a set of companies in very different sectors that have records of growth and steadily increasing dividends to give you both a regular income and the expectation of useful capital gains over a five-year period.
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