Dividend Growth Stocks: An Attractive Proposition Amid Uncertainties

The market conditions around the world are full of domestic and geopolitical uncertainties, which is making investors worried over a future downturn or a recession. Experts are fretting about the potential of a large-scale conflict between the United States and Iran, on the same time there is no certainty that the trade dispute between the US and China would be solved in a reasonable time period, and the inversion of the yield curve has compounded the fears. Many experts believe that the developed world would be hit by a recession in the next six to eighteen months, at a time when the financial and political landscape already looks fragile.

Investors started to worry about a potential decline in the economy and equities after the US initiated a trade war with China. The dispute is currently not the focus of investors tension as both the countries have agreed to a ceasefire and agreed to the resumption of negotiation after the US began planning to hit an additional $300bn of Chinese goods. But matters look far from resolved and hopes of an agreement in the near future are not very high, as earlier a truce agreed last December collapsed and subsequently the US raised tariffs on $200bn of Chinese products to 25 per cent from 10 per cent in May, hitting the global supply chain and impacting corporate earnings.

The Gulf crisis has dangerously escalated in recent times, threatening to disrupt the all-important Strait of Hormuz, which carries about a fifth of the world's oil and a quarter of its natural gas. Tensions have risen after Iran seized a British-flagged tanker in the Persian Gulf in retaliation to an Iranian tanker being captured by the British navy, and an Iranian drone shot down by the US army. Moreover, Iran has already breached parts of its nuclear agreement and has threatened with more actions if the issue is not resolved. This has gravely impacted the markets worldwide, resulting in demand for gold and sovereign bonds. Oil prices have also shot up due to the crises.

Investors are also worried about the inverted yield curve in the US, which has been without fail an accurate harbinger of recession, signalling doubts about future growth. The current expansion started in March 2009 when the US broader indices bottomed after experiencing a financial crisis, but the ongoing bull rally is the longest in history, handsomely beating a historical average of just four and half years. This has made investors worried that the recession is just around the corner, as many indicators suggest that the expansion has started to fizzle out. Since the modern quarterly record-keeping started in the year 1992, Chinese economy recorded the slowest pace of growth in the April-June period of 2019, when Chinese economic growth hit a 27-year low amid ongoing trade war, as per official data revealed on 15 July 2019. As demand from China was the major driver of global economic growth, the slowdown in the country has caused jitters amongst many investors.

Amid all the global geopolitical issues and uncertainties, the threat of disruption due to Brexit is the most significant cause of worry for domestic investors. On 23 June 2019, it was declared that Boris Johnson had beaten Jeremy Hunt in Tory leadership contest to become the next prime minister of the United Kingdom. The worst fears of the investors had come true as a hard-Brexiteer was due to lead the country in its worst political period in modern history. The chances that the UK will be dragged into a recession post a disorderly Brexit has risen with his selection as the chances of a no-deal Brexit have risen. A recent report by the Office for Budget Responsibility suggested that the stock market declined by 5 per cent in the immediate quarter in the event of a hard-Brexit, forcing the central bank to cut its already historically low policy rates

However, the FTSE 100 index does not seem to follow the pessimistic trend and has risen of late, supported by the weakening of the Pound. Since most of the constituents of the index are internationally focussed companies, a weaker Sterling increases their earnings on a local currency basis, providing them with a boost. However, experts reckon that both the equity market and foreign exchange market would be severely impacted, with some predicting that the Pound will fall to $1.

Historically, it has been seen that dividends are much less volatile than stock prices as the management of the company is more reluctant to cut dividends in the face of volatility in share price, for fear of sending negative signals to the market. The dividend growth strategy might not be the most exciting strategy, but it has proved to be an effective one to generate good returns in the long run with lower volatility, though these stocks can be outperformed by non-dividend-paying momentum stocks in the short term.

In a world of limited capital appreciation or even negative returns, due to various factors, the importance of reliable and growing dividends increases as a rise in dividends would help in driving higher future dividend yields, bolstering the long-term total return. Moreover, the relative attractiveness of dividend growth equities would increase in a world of falling interest rate, which would drive bond yields lower, which would limit potential future bond capital appreciation. Dividend stocks would retain the potential for higher capital appreciation and can provide an alternative to stagnant fixed income coupons. Dividends also tend to rise at least in line with inflation, which might offer a hedge against the potential impact of rising inflation, making them a popular investment choice with retirees.

Imperial Brands

Imperial Brands PLC (IMB), is a fast-moving consumer goods (FMCG) company with a core business built around a tobacco portfolio. The company offers a comprehensive range of cigarettes, fine cut and smokeless tobaccos, papers and cigars and is increasingly focusing its attention on developing and expanding it’s Next Generation Products (NGP) portfolio. The group is headquartered in the Bristol, the United Kingdom. The company's operations are differentiated in two segments: Tobacco & NGP and Distribution. Within Tobacco & NGP, the operations are further divided into Returns Markets North and Returns Markets South.

As on 23 July 2019, the stock was trading at a dividend yield of 10.43 per cent with a forward price/earnings ratio of 7.2x as compared to the industry median of 14.6 per cent. The industry median of forward dividend yield is 3.4 per cent. This shows that the company pays an attractive dividend and has the potential to offer attractive capital appreciation. Moreover, the dividend yield is significantly more than the yield of FTSE 100, which was 4.40 per cent as on 23 July 2019. It is also higher than the British sovereign bold yield, which has been on a declining spree and is expected to fall further in the coming months. However, according to the projections made by analysts and posted on the website of the company, dividends are expected to increase to 205p per share in the financial year 2019 and 218.5p in FY 2020, against a payment of 187.8 made in FY 2018. In the latest half-yearly results, the company increased its interim dividend by 10 per cent despite a sharp fall in recent months, highlighting the stability of dividends. The policy of the company is to deliver dividend growth of at least 10 per cent in the medium run, and it has achieved its target for the last ten consecutive years, reflecting the continued strong cash generation and the importance of growing dividends for shareholders. Moreover, depending on the market condition, the company in its recent revised capital allocation and dividend policy announced that any surplus cash flows would be returned to the shareholders via share buybacks, enhanced ordinary dividends or special dividends.

Share Price and Gross Annual Dividend Payment

Weekly Chart as at July-23-19, before the market closed (Source: Thomson Reuters)

The chart shows the share price of the company compared with its annual dividend since the start of 2008. Even though the world faced a recession during the 2008-09 financial crisis, the company did not decrease its dividend, rather had progressively increased it. Moreover, despite the volatility faced by the company in more than a decade, such volatility in dividend payments has not been seen, strengthening the case for dividends as a source of reliable and stable returns in the face of macro uncertainties.

Conclusion

With investors reallocating capital out of risky assets and into safe havens, good returns can be expected out of stocks which offer reliable dividend with limited exposure to worldwide tensions and domestic uncertainties. Amid increased chances for a hard Brexit and ongoing global worries. It should be remembered that the historically strong dividend does not automatically mean a strong dividend in the future. Investors must analyse the business model of the company to understand its flow of cash and expenses to ensure the continuity of dividends.