2017 could be the year that dividend growth becomes the most important aspect of income investing.
In 2016 and recent years, low levels of inflation have meant that investors focused on higher yielding stocks. While this was enough when inflation has been at or near zero, a faster rising price level could mean that the market favours fast growing dividends over high yields.
For companies which are stifled by high payout ratios, lacklustre earnings growth and large interest repayments stemming from high debt levels, this could be a problem. Their dividend growth may be unable to keep pace with inflation and their share prices could suffer.
However, for companies such as RSA Insurance (LON:RSA), a renewed focus by investors on dividend growth could be a fillip. It is due to raise dividends per share by over 40% in 2017. It should also benefit from continued improvements in its operating performance and a low valuation over the next year.
A changing landscape
Dividend investors have enjoyed a relatively calm period since the global financial crisis. Interest rates have been at 0.5% or lower, inflation has remained below historic levels and the UK and global economies have generally been relatively subdued.
However, that is all due to change in 2017. Notably, inflation is forecast to reach 2.7% according to The Bank of England, although there is a good chance that this will prove to be a conservative estimate. Other estimates such as that from The National Institute of Economic and Social Research have the figure at 4% over the next year.
Undoubtedly, the main cause of higher inflation will be weaker sterling. It may have fallen by between 15% and 20% since the EU referendum, but is likely to depreciate further in my view, particularly against the US dollar, since the Federal Reserve is becoming increasingly hawkish.
Furthermore, confidence in the UK economy could fall since Brexit negotiations will commence prior to the end of Q1. With a stalemate between the UK and EU and a ‘hard’ Brexit seeming likely, sterling could weaken in 2017 and send inflation higher.
Dividend growth appeal
Therefore, even if a stock has a high yield, it could offer a real decline in income in 2017. This could cause investors to switch to companies which offer dividend growth that can keep up with inflation. Such companies may be relatively hard to come by, however, since the outlook for the world economy is uncertain.
…if interest rates are raised to cool inflation, fast-growing high-yielders could be among the most coveted stocks next year.
A new US President, turbulence in the EU/Eurozone and a slowing China could combine to stifle economic growth. Companies which are able to increase dividends through a rising payout ratio, improved profitability or through leveraging their balance sheet could become more popular due in part to their scarcity value.
Furthermore, if interest rates are raised to cool inflation, fast-growing high-yielders could be among the most coveted stocks next year.
2017’s fastest growing dividend stock?
Due to the potential for companies with fast-growing dividends to perform well in 2017, RSA Insurance has appeal. It only yields 2.6% today, but it is due to raise dividends by 40.3% in 2017. This could make it one of the fastest growing dividend stocks in the UK index, and it is being paid for out of a mix of a slightly higher payout ratio and improving operating performance.
RSA is forecast to increase its payout ratio by 1% next year, which will put it at 48% versus 47% for 2016. Therefore, in spite of such a large planned increase in dividends, there is still the prospect of a higher payout ratio to boost payouts over the medium term.
In fact, the company is targeting a payout ratio of up to 50% plus special dividends over the medium term. The bulk of the 40%+ forecast rise in dividends next year will be from improved financial performance as RSA gradually continues to benefit from a sound strategy.
In terms of RSA’s operational improvements, it has completed a large disposal programme. This has totalled around £1.2 billion, taken two years to complete and left a more appealing core business.
The ‘new’ RSA has a superior risk/reward ratio than the ‘old’ RSA and should position the company for better performance in the long run. It has also cut costs and is on target to deliver £350 million in cost savings by 2018. This has taken place alongside a deleveraging process. For example, in the first half of the current year around £200 million of subordinated debt was retired.
The ‘new’ RSA has a superior risk/reward ratio than the ‘old’ RSA…
In spite of these improvements, RSA has a relatively low valuation. Its P/E ratio of 17.8 is due to drop to 13 next year. Given the company’s positive outlook, I feel this is fair. Further evidence of an appealing valuation is evidenced by its prospective yield for 2017 of 3.7%.
Given the risks facing the global economy, 2017 is a challenging year to forecast. However, higher inflation seems likely and this could cause income investors to pivot away from high yielding, slow dividend growth stocks and towards lower yields from stocks which have superior dividend growth potential. The risk of negative real income growth could spur this change.
Since uncertainty from Brexit in particular is likely to rise, sterling could weaken and the pound could depreciate further. Therefore, inflation may overshoot The Bank of England’s current target.
In such a climate, RSA has appeal. Its yield may be low today, but rapid growth in 2017 and the potential for further growth in 2018 mean that it could become more popular among income investors. Its operational improvements mean that its business is now lower risk and offers potentially higher rewards than in recent years, which bodes well for the long term.
Trading at a fair price and with an upbeat outlook, the search for dividend growth leads to RSA in my view.