Two ways to invest in dividends with only £2,000

Investing for income on a limited budget isn't easy. It's tempting to go for the highest dividend yields you can find in order to feel that you're getting a worthwhile return.

But this approach can be risky -- yields of more than about 6% often indicate that problems may lie ahead. Today I'm looking at two dividend stocks with attractive yields that are well supported by earnings. Does either of these companies deserve my buy rating?

Recent falls could make this a buy

Shares in floorcovering distributor Headlam Group (LSE: HEAD) fell by 7% in early trade this morning. A solid set of 2017 results were overshadowed by news that January trading fell below expectations.

This group buys products such as carpets, tiles and laminates from suppliers in 16 countries, and sells through a network of 63 fully-owned distribution businesses in the UK and Europe.

Like-for-like sales fell by 5.9% in January, thanks to a weaker performance in the residential sector and "a reduction in orders from one of our larger customers". This trend continued in February when is sales performance was said to be "similar" to January.

Despite this, the company has left its 2018 guidance unchanged. It's still early in the year and management believes that its strategy of improving profitability and making selective acquisitions means forecasts for this year are still valid.

My view

Headlam's sales rose by 2% to £707.8m last year, while underlying pre-tax profit rose 7.3% to £43.1m. The board took advantage of improved cash generation to increase the dividend by 10% to 24.8p, giving a trailing yield of more than 5%.

The firm's focus on increasing its profit margins seems to be paying off, but it's worth noting that like-for-like sales in the UK only rose by 0.5% last year.

Although the group also operates in Europe, the UK accounted for 97% of operating profit last year, so falling sales here are a concern.

Analysts expect the group's adjusted earnings to rise by around 15% to 45.1p per share this year. This puts the stock on a forecast P/E of 11 with a prospective dividend yield of 5.5%. I suspect these forecasts will be cut following today's results so I'd probably rate the shares as a hold until the outlook becomes clearer.

A cash machine with a 6.8% yield

Sofa and carpets retailer SCS Group (LSE: SCS) is a well-known sight on retail parks across the UK. It's a cyclical business that's dependent on consumer spending and affordable credit for growth.

When times are good -- as they have been -- SCS performs very well. The group's net profit has risen from £2.6m in 2013 to £9.4m in 2017. Trading so far this year has been solid.

In January, the firm reported like-for-like order growth of 2.2% for the six months to 27 January. However, analysts expect profit growth to be broadly flat this year, suggesting that profit margins may be coming under pressure.

The stock's valuation is undemanding, on just 9.5 times forecast earnings. Profits have been backed up by strong cash generation in recent years, and a dividend of 14.9p per share is forecast for this year, giving a prospective yield of 6.7%.

If you believe the UK economy is likely to remain healthy, SCS could be a rewarding buy.

I'd buy these dividends today

The big risk for investors in Headlam and SCS is that their profits are cyclical. If the housing market crashes or the UK suffers a recession, profits could collapse.

That's why I'd always be sure to have some defensive dividend stocks in my portfolio. Classic defensive sectors include pharmaceuticals and utilities.

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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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