Dividends are an essential part of investing. They give you a steady income no matter what the market environment and can be reinvested to accelerate your investment returns over time.
However, finding the best dividend stocks is an art. The best dividend payers aren't all that distinct and they usually hide out of plain sight, but when the market discovers their potential, they can rapidly surge in price.
So what makes the perfect hidden dividend stock? Well, they clearly tend to offer a higher than average dividend yield that's well covered by earnings per share. What's more, these companies have healthy balance sheets with little debt and robust cash flows that easily cover dividend payouts as well as capital spending.
Lancashire Holdings(LSE: LRE) is an excellent example of one of the market's best-hidden dividend stocks.
Difficult to understand
Lancashire is an insurance business. It has no demanding capital spending requirements and due to the nature of insurance (payments upfront and possible payouts later), the business is well-funded.
Further, its management is one of the best in the industry at claims estimation, meaning that the business constantly over reserves for potential losses and as a result, often finds itself with too much extra capital. The company returns all of this additional capital to investors. For the past three years, the group has returned more than 100% of income to shareholders via special dividends, which has meant a yield of 10% or more for investors every year.
Lancashire's status as a hidden dividend champion is likely to persist as insurance is a lumpy business that few understand. Moreover, the company tends to pay one large special dividend every year, rather than smaller regular payouts, which may put some dividend hunters off the company.
City analysts are expecting the company to pay a dividend of 50p per share this year for a yield of 7.3%. The shares trade at forward P/E of 13.6.
Shares in Epwin(LSE: EPW) currently support a dividend yield of 6.6%, nearly double the market average. And this payout looks safer than that of many so-called dividend champions as Epwin is a cash cow.
Last year the company's operations generated £22m of cash, capital spending came to £9m and the dividend only cost £6.7m. With the money left over, plus borrowing, the group acquired two businesses to help drive growth.
During the first half of 2016, Epwin generated £8.2m in cash from operations, spent £8.3m on capital expansion and acquired yet another business. Including the dividend, cash outflows totalled £23m with the difference funded with debt. At the end of the period, Epwin reported net debt of £29.9m.
City analysts are expecting the company to report a net profit of £20m for 2016. Considering Epwin usually converts around 80% of net profit to cash, it's reasonable to assume the group will report a cash inflow of £16m for the full year, which gives management plenty of headroom to pay down debt and support the dividend.
The shares trade at a forward P/E of 7.2.
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Rupert Hargreaves owns shares of Lancashire Holdings. 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.