Hunting for the market's best income stocks is a tough process. It's not as simple as just finding the stocks with the highest dividend yields, you need to uncover the stocks with the most potential for dividend growth. These companies usually produce the best results over time.
Glencore(LSE: GLEN) is one such company. While the commodities trading house isn't what you'd call a 'dividend champion' today with a prospective dividend yield of 2.5%, it is producing more cash than it knows what to do with.
Back to health
Glencore's recovery from its near-death experience in 2015 has been extraordinary. Results for the six months to June hit market expectations, with pre-tax profits of $2.5bn, up from a loss of $369m last year. Revenues rose 45% to $100bn, and net debt dropped 40% to $13.9bn, pulling the net debt-to-underlying earnings ratio down to 1 times, well below management's self-imposed ceiling of two. If the company repeats its first-half performance in the second half, management expects the group to produce $7bn of free cash flow for the year.
With plenty of cash on hand, management reportedly considered paying a special dividend to investors alongside its mid-year results, but stuck to its previously announced plan to return $1bn to shareholders in 2017.
In 2018 a new dividend policy will come into force which could see the miner return an estimated $2.5bn to investors based on profits. Analysts have pencilled in a dividend per share of 13.1p for 2018, giving a yield of 3.8%.
While I'm optimistic about the outlook for Glencore's dividend, I believe that Burberry's (LSE: BRBY) outlook is more downbeat.
Burberry is one of the FTSE 100's dividend champions, but right now the shares yield only 2.3%. The company is also undertaking a buyback to return additional cash to investors. City analysts expect the company to increase its dividend payout by around 10% for the fiscal year ending 31 March 2019.
However, worries are starting to arise regarding Burberry's sales growth. The business has been trying to cut costs to boost earnings during the past few years, which is working to a certain extent, but this is not a long-term solution. Indeed, City analysts believe that the company will chalk up revenue growth of £100m for the three years ending 31 March 2019. Over the same period, pre-tax profit is expected to expand by £117m.
As shares in Burberry trade at a premium valuation of 22.3 times forward earnings, if sales growth starts to slow, the market will re-rate the shares lower meaning capital losses for investors. Such capital losses could wipe out any dividend gains and force management to spend more rekindling sales growth, putting further downward pressure on profits.
That being said, I don't think that Burberry's dividend payout is in imminent danger as the payout is covered twice by earnings per share. Nonetheless, any growth slowdown will hit the value of the shares.
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Dividend stocks are portfolio essentials as over the long term, dividends account for around half of equity returns. That's why it's important to find the stocks with the most secure dividends.
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Rupert Hargreaves does not own shares in any company mentioned. The Motley Fool UK has recommended Burberry. 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.