The dividend stocks to buy (and the ones to avoid)

The FTSE 100 may not be able to offer investors the racy AI companies that are driving stock market returns more widely, but London’s more traditional sectors can instead offer something arguably more important: dividends. 

Reinvested dividends have historically accounted for a critical part of total returns, while a reliable dividend record often serves as an indicator that a company’s management is disciplined with its cash and acts in investors’ interests. 

How you use dividend stocks depends on your investment goals – while younger investors may want their payouts to boost the value of their portfolio and therefore choose to reinvest their divis in more shares, older investors may rely on their dividends to supplement their retirement income. 

Whatever your intentions, Telegraph Money has picked out a range of London’s most compelling dividend stocks across a range of sectors and at varying yields.

Legal & General

Yield: 7.7pc 

Legal & General boasts one of the highest yields in the FTSE 100, at almost 8pc, and is a popular stock among income fund managers. 

The shares have been rocky for much of the past five years, but overall stand just 3pc lower over the period. The insurer has an excellent record for income investors – it is one of the few companies to have kept up payouts during the pandemic and has been steadily increasing its cash returns to shareholders for the past four years. 

In its latest results it said it would increase its interim dividend by 5pc and would maintain this rate of growth in 2024. 

Its longstanding chief executive Sir Nigel Wilson stepped down at the end of last year and the arrival of new boss always comes with some risk. 

Its wobbly share price of recent years reflects accounting changes and concerns over the impact of higher interest rates on the value of the assets looked after by its fund management arm. However, the business offers a strong record of profitability, a very high yield and a low valuation.

Relx

Yield: 1.7pc

Buying only stocks that offer the highest yields is rarely a good idea; a balanced portfolio that can promise both a decent yield and income growth needs some lower but reliable yielders that look well-placed to grow their divis. Relx fits well into this category. 

It is an analytics company that provides data to businesses, healthcare professionals and governments. More than half of its revenues come from recurring subscriptions, which give it predictable cash flows, and its profits have been on a steady upward trajectory. 

Relx aims to grow dividends in line with its earnings per share and to ensure that profits cover dividends twice over, which makes the payments less susceptible to shocks. Last year a 17pc rise in earnings resulted in a 10pc increase in its dividend.

BP

Yield: 4.4pc

Some of the FTSE 100’s biggest and most reliable dividend payers are in the oil and gas sector, which can make income investing more challenging for savers who would prefer to avoid this sector. William Lamond of the wealth management firm Oakglen Wealth highlighted BP as an income pick. 

“BP reviewed its dividend policy during the pandemic. It is now a leaner business that generates strong free cash flow, even when crude oil trades at $50 a barrel,” he said. 

The current price is about $80 a barrel. “With the current market manipulation of Opec to reduce supply to keep the crude oil price elevated as well as significant underinvestment in new assets in the Western world, BP looks well positioned to benefit from elevated levels of profitability and free cash flow,” Mr Lamond said. 

He added that the company had been vocal about its drive to fund growth in alternative energy. “This should position BP to take advantage of the ongoing energy transition to more environmentally friendly sources as well as diversify earnings from fossil fuels,” he said. 

“It has also enabled management to reallocate cash to shareholders through increased dividends and share buybacks.” 

After an 11pc fall in the shares over the past five years they trade at less than seven times forecast earnings for 2024, which is well below the average of about 10 for London-listed stocks.

Dunelm

Yield: 3.9pc 

Imran Sattar,  deputy manager of the Edinburgh investment trust, has about 4pc of the fund’s money in the homewares retailer Dunelm. 

“With a combined approximate 7pc market share in homewares and furniture, there is plenty of room to gain share in the market through its store roll-out plans, digital investment strategy and ability to gain share in furniture in particular,” he said. 

“The shares yield about 4pc but with Dunelm’s excellent record of cash generation the company has been able to pay special dividends too. For example, it has paid a special dividend in each of the past three years and the total yield will be closer to 8pc if these special dividends continue.”

HSBC

Yield: 4.4pc

Banks have long been a staple of the income investor’s portfolio. Richard Hunter of the broker Interactive Investor said that, despite recent share price weakness, several FTSE 100 banks looked compelling. 

“Their capital cushions are extremely robust and likely to provide enough support for any impending storms,” he said. “The annual results season in February could provide the opportunity for further shareholder returns, such as share buybacks.” 

Mr Hunter highlighted HSBC, whose net interest margin – the difference between the interest it charges on loans and the interest it pays to savers – has been boosted by higher interest rates. 

The bank has also increased the proportion of profits it will pay in dividends to 50pc for 2023 and 2024. 

Meanwhile the expected sale of its Canadian business to Royal Bank of Canada could, say analysts at the broker Jefferies, unlock an estimated $4bn dividend and help fund $22bn worth of share buybacks over the course of 2023 to 2025.

Buybacks do not automatically boost dividends but enhance earnings per share because profits are apportioned to a smaller number of shares. An increase in earnings per share makes a higher divi more likely.

Red flags for dividend stocks

Russ Mould of the broker AJ Bell said the rule of thumb is that any dividend yield more than twice the “risk-free rate” – the yield on 10-year gilts – is probably too good to be true. 

“Right now 10-year gilts yield 3.9pc, so any yield on offer above about 8pc needs careful study,” he said. 

For example, Vodafone’s yield of about 11pc is the highest on London’s FTSE 100. Its yield has been boosted by a severe decline in the share price, which has dropped by more than a quarter in the past year alone. Profits have been falling and some analysts expect the company to cut its dividend either this year or next. 

Mould said “earnings cover” for a dividend should ideally be two or more. Earnings cover is the ratio of earnings per share to dividends per share. 

“Allowances can be made for certain industries where earnings are fairly predictable, but anything volatile or cyclical needs looking at if the ratio is below two,” he said. “It may be best to look at average cover over say 10 years, or a full economic cycle, to make sure this year isn’t one in which cover looks good because earnings are at a cyclical high.” 

The health of a company’s balance sheet is also critical to its ability to maintain dividend payments. “A heavily indebted company will have to pay interest on its liabilities and repay them at some stage,” Mould said. “Ultimately a firm could have to reduce or even suspend its dividend to preserve cash and ensure its banks are paid so they do not pull the plug.” 

He said one good measure of the strength of a company’s balance sheet was its “gearing”, or the ratio of its net debts to net assets. It is calculated by first adding short-term borrowings to long-term borrowings and pension liabilities and taking away cash and “cash equivalents”. This figure is then divided by shareholders’ equity (or “net assets” or “book value”) and then multiplied by 100 to reach a percentage. 

“A positive figure shows the company has net debt, a negative one net cash,” Mould said. “Crudely put, the lower the ratio the stronger the balance sheet. However, companies with relatively predictable cash flows, such as utilities, will be able to carry higher debts more comfortably than cyclical ones, whose income swings around in a much less predictable manner.”