Income investing is about more than just picking stocks with high dividend yields. A high yield may simply be a symptom of a falling share price, and this could be seen as a warning sign that investors doubt the company's dividend sustainability.
This puts high yielding stocks at greater risk of dividend cuts, and shareholders in BHP Billiton,Rio Tinto, Rolls-Royce and Barclays are sure to have learned this the hard way, with all four FTSE 100 companies announcing big dividend cuts this year.
Instead, investors should look out for companies with reliable cash flows and sound fundamentals. Companies with robust dividend cover and steady dividend growth may have less attractive yields, but they tend to deliver superior income growth and capital appreciation in the longer term.
With this in mind, here are 3 stocks that seem to fit the bill:
BT's (LSE: BT-A) acquisition of EE brings together the market leaders in both the fixed-line and mobile telecom sectors. The combination of these two giants creates a formidable force in the telecoms market, enabling BT to compete more effectively against rivals Sky and Virgin Media.
BT expects to generate around £360m in annual cost and capex synergies from the deal, with revenue synergies from cross-selling expected to add a total net present value of approximately £1.6bn. With top-line and bottom-line improvements, this should massively benefit free cash flow generation and support further dividend growth.
Free cash flow can already cover its dividend by more than 2.8 times, with adjusted earnings cover of 2.5 times. This shows there is plenty of room for increased shareholder payouts, which city analysts seem to agree. The consensus forecast is for dividends to grow by 13% this year, giving the stock a prospective yield of 3.2%. For 2017 and 2018, its prospective yield is forecast to rise to 3.6% and 4.0%, respectively.
Babcock International(LSE: BAB) has an excellent long-term track record for delivering dividend growth and capital appreciation. Despite recent share price weakness, Babcock has delivered a capital return of 64% over the past 5-years, with dividend per share growing by an average compound annual growth rate (CAGR) of 13%.
Babcock's impressive track record gives us confidence about the company's dividend growth prospects. This is especially true given that the dividend cover stands at 2.9x. Fundamentals are looking positive, too, with growing public sector contract numbers contributing to strong revenue growth and improving revenue predictability.
With the stock now trading at 12.8 times expected 2015/6 earnings, you can't complain about Babcock's valuation either. Its dividend yield may only be worth 2.5% now, but dividends are forecast to grow by at least 9% annually for each of the next three years.
Thomas Cook Group (LSE: TCG) is controversial pick. Over-expansion and excess leverage brought the company to a near bankruptcy in 2011, and it has yet to restart dividend payments.
But being a well-recognised brand with a high degree of customer loyalty, Thomas Cook has been able to quickly turn things around. Profits are bouncing back strongly and its balance sheet is in much better shape. Net debt has fallen sharply - to just £139 million in 2015 - with the company likely to become debt free later this year.
Management expects to resume dividend payments in early 2017 in respect of 2016's full-year earnings. City analysts expect it will initially pay around 20-25% of its adjusted earnings, which would equate to around 2.3p per share, based on expectations that underlying EPS will climb 20% this year, to 10.7p. On these estimates, its shares carry a prospective dividend yield of 2.5%.
With expectations of double-digit earnings growth over the next few years and a steady increase in its payout ratio, the outlook for the stock's dividend growth is extremely exciting. Valuations are attractive too, with Thomas Cook trading at a forward P/E of just 8.6.
Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.