Screen test will reveal companies with star quality

Anumber of readers have e-mailed me over the last few weeks about my gnomic comments on “quality” dividend-paying stocks, following the BP debacle. When I say there’s still lots of “quality” around, what exactly do I mean?

This term can mean different things to different analysts and fund managers – but, scratch away all the jargon, and you end up with a loose term for companies that are still growing at a gentle pace (pushing up earnings per share); paying a competitive dividend that is well covered by earnings; and boasting a strong balance sheet.

Admittedly, this does sounds a bit “motherhood and apple pie” – after all, who wouldn’t want these kind of companies? However, if you apply methodologically rigorous filters or screens to the UK stock market, you can begin to see what a quality company looks like.

In general, there are two schools of thought on this.

The first maintains that a cheap share price, chunky dividend and a strong balance sheet should outweigh any consideration of future earnings growth. It tends to attract contrarian, value-driven investors who are dismissive of earnings projections and prefer to focus on the cashflow line and the balance sheet, with an inevitable bias overall towards defensive sectors.

The second school of thought favours “growth at a reasonable price” and suggests that, while the dividend is crucial, it’s more important to find a company that is still growing at a sustainable rate, with low debts and lots of cash inflows. It is led by fund managers such as Mark Burnett at Invesco Perpetual – he tends to be overweight in solid growth stocks such as Serco, where the yield isn’t quite as attractive as the business franchise and the potential for growth.

Personally, I am more inclined to the former school, as it tends to reward patient long-term investors who can find companies where the dividend is constantly growing – ie it is “progressive” – and can be easily reinvested.

In fact, I believe the dividend yield on offer from these companies is enormously attractive at this juncture, as the perception of macro-risk seems to grow by the day.

I agree with a note from brokers Killik & Co last week that said: “Even though a number of companies have cut or reduced their dividends over the last couple of years, the prospective yield on equities, even after adjusting for the suspension of payments by BP, is currently around 3.9 per cent. This is currently well ahead of its 30-year average (3.1 per cent) and the return on cash and UK government bonds. After a period of financial prudence, many companies have come through the recession in rude health. Cost bases have been re-aligned, so that the recovery in sales has led to a sharp increase in profitability and free cash flow due to operational gearing. As a result, strong corporate balance sheets provide the flexibility to pay progressive dividends to shareholders.”

The key for me is that word “progressive” – where a company’s management has publicly committed to growing the payout year in, year out – hopefully at a rate that is above inflation. As Killik noted: “A progressive policy is a sign of management’s confidence in the outlook for the company. In addition, a growing dividend stream contrasts with the flat income derived from both corporate and government bonds, and provides protection from inflation over the long term”.

So which UK companies would a “progressive” dividend stock screen currently identify? I’ve studied three screens.

First, a Killik screen that searches for progressive dividend payers with more than £1.50 in cash earnings for every £1 of dividend paid out, decent cashflow and a solid balance sheet.

Second, a screen by the French bank SocGen that looks for companies with really strong financial controls and balance sheets – it uses ideas developed by a US academic called Joseph Piotroski plus a model for debt called the Merton model.

Third, my own screen to pick out FTSE 350 companies that have increased their dividends every year for the last five years, have strong earnings cover and projected earnings per share growth in the next 12 months.

Putting these three screens together, I come up with this diversified, progressive “starter for ten” portfolio: AstraZeneca, Halfords, BAT, Vodafone, FirstGroup and BAe Systems.

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