European income investors have only just recovered from the coronavirus pandemic, only to be faced with the prospect of soaring inflation.
With inflation at nearly 6% in the Eurozone and UK, many stocks’ dividend yields will fall short of price increases. Supply chain problems are also a concern, and interest rate rises due this year will also squeeze incomes, increasing debt costs and changing the investment focus away from growth stocks.
Morningstar analysts have looked at the 300+ names under our coverage for companies best placed to navigate this hostile terrain. Some 28 companies make the cut and they come from a wide range of industries.
What many have in common are pricing power, often as a result of having economic moats, low debt levels and strong cash flows.
Utilities, banks and energy firms were key dividend stocks before the pandemic, and they are still strongly represented in this list. The financial sector, for example, is still a happy hunting ground for dividend seekers. But consumer-focused firms like Hugo Boss (BOSS), BMW (BMW) and H&M (HMB) rub shoulders in our list with the likes of Tesco (TSCO) and wide-moat pharma giants Novartis (NOVN) and Sanofi (SAN).
Morningstar senior equity analyst Michael Field points out European income investors looking for sustainable high yields are faced with a wider choice than in previous years.
“Given both the rally in equity markets in 2021, which drove share prices up and dividend yields down, and the low interest-rate environment, in which investment income across sectors has been relatively hard to come by, we think income investors should be particularly encouraged by the diverse nature of the names on this list,” he says.
“It is still possible to generate a solid income of 4% average dividend yield across our list without leaning too heavily on specific sectors and retaining the benefit of diversification.”
How Field's Team Did It
Here's how our team of analysts came up with its list:
- Companies must have low or manageable financial gearing, i.e. low borrowing as a percentage of profits. That’s expressed in the column “Net debt/EBITDA”;
- They must also have enough cash flow to finance their dividend. This is described in terms of five-year free cash flow yield. We’ve set a hurdle rate of a 3% yield for this exercise;
- Ideally, companies must have some form of competitive advantage – 18 of our stocks have a narrow or wide economic moat.
European stocks could be well placed in the current environment, Field argues.
The European Central Bank is unlikely to be as aggressive in raising interest rates as the Federal Reserve, giving companies on the continent some headroom. But interest rate rises are likely to favour “short duration” names that focus on generating cash in the here and now. In this tough environment, indebted firms are likely to struggle further. That’s why the list screens out companies with a high level of borrowing.
Despite the risks of interest rate rises, the gap between government bond yields and corporate dividends is still vast. This makes the income-seeking investor’s life easier because bond yields are still not tempting despite recent rises.
“This argument for stocks versus bonds from an income perspective makes even more sense in Europe than the US,” Field says.
Beware Dividend Cuts
Income investors who suffered from the wave of dividend cuts in 2020 will doubtless remain on the alert for stocks that are struggling to meet payout timetables.
“Paying a dividend is one thing, but being able to pay a dividend is something else entirely,” says Field.
“We do look specifically at the cash flow projections, as opposed to earnings, for each of our stocks to ensure that there is no mismatch between what investors are expecting in the form of dividends and what companies can realistically pay with the funds they are likely to generate.”
Nothing is guaranteed in the world of investing, but Field says the latest stock screen tilts the odds in favour of those firms likely to keep paying.
“By identifying only firms with the ability to cover future dividends with cash flows, we believe we are giving ourselves the very best chance at sustainable income returns.”
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