How I'm hunting for UK dividend hero stocks

I’m an incurable tinkerer, so during the brief, intermittent and generally disappointing summer of 2024, I spent a fair amount of time dreaming up ways to improve how I select, value and manage a portfolio of dividend stocks.

Eventually, I came up with a handful of tweaks that should help me (and perhaps you) build a more concentrated portfolio of higher-quality stocks, purchased and held at more attractive valuations. 

Today, I’ll focus on the quality-related changes that I've made, and in a couple of follow-up posts, I’ll cover the changes that relate to valuations and portfolio concentration/diversity.

Ten years of consistent dividend growth isn’t enough

When I analyse a potential investment, the first thing I do is review its financial results from the previous ten years. In other words, I look at growth over ten years, profitability over ten years, capex over ten years and so on.

This makes a lot of sense because I’m a long-term investor and I expect to hold each investment for at least five or ten years, so I should look at least five or ten years into the past to understand how the business might perform over that sort of timescale.

However, although ten years is quite a long time, it isn’t always enough to capture a full economic cycle. That's a problem because if we don't look at a full economic cycle, we're not getting the full picture.

That's because, during the expansion phase of the economic cycle, good companies, bad companies and ugly companies can all produce decent profits and consistent growth, year after year, so only looking at the expansion phase can be misleading.

On the other hand, when the tide goes out we get to see who was swimming naked, so during the contraction phase of the cycle the bad and ugly companies will typically struggle, while the good companies will usually continue to perform well, or at least well relative to their bad and ugly peers.

So we need to look at the full cycle to get the full picture, otherwise we may end up investing on a faulty premise.

For example, when I invested in Headlam (the UK’s leading floorcovering distributor) in 2018, it had an impressive track record of steady growth across revenues, earnings and dividends going back ten years to 2009. That was exactly what I wanted to see, and it’s one of the reasons I invested.

Unfortunately, 2009 wasn’t just any old year. It was the absolute nadir of the global financial crisis and it marked the end of the previous cycle and the beginning of the next cycle. It was also the year in which Headlam's revenues, earnings and dividends were rebased to a significantly lower level.

After 2009, the economy slowly recovered and Headlam slowly recovered along with it, raising its revenues, earnings and dividends steadily over the following ten years. But this wasn't new growth to new highs, it was Headlam being lifted by a rising tide back to levels it had first reached in 2007, just before the financial crisis hit.

I was aware of this, but because looking back beyond ten years wasn't a formal part of my investment process, I didn't pay enough attention to the fact that the 2009-2018 period only covered the expansion phase of the economic cycle, and that was a mistake. 

The obvious solution is to look further back in time so that I’m always looking at one full economic cycle, at the very least, and that's exactly what I've done.

Twenty years of consistent dividend growth is better than ten

My solution is to look back 20 years, rather than ten, because 20 years has always been long enough to capture a complete economic cycle, or at least it has been since the beginning of the 20th century.

More specifically, I now measure companies against the gold standard of having a perfect track record of progressive dividend growth stretching back at least 20 years.

Various names have been given to dividend stocks based on the length of their progressive dividend records, with Dividend Kings having a 50-year unbroken record of growing or maintaining their dividend and Dividend Aristocrats amassing a more attainable 25-year record. There isn't a name for stocks with a 20-year progressive dividend record, but Dividend Hero is the name given to investment trusts with at least 20 years of progressive dividend growth, so I think "dividend hero stocks" is as good a name as any. 

These dividend hero stocks are the gold standard for dividend investors for at least two reasons.

First, they have a proven ability to pay consistent and growing dividends in good times or bad. In other words, when there's an economic downturn, they aren't so cyclical or highly indebted that they're unable to maintain or sustain their dividends. This is obviously important because income investors still need to pay the bills, even if there's a recession.

Second, they have a proven desire to pay consistent and growing dividends. In other words, they have a strong dividend culture, where paying a progressive dividend is important to the company’s board and its major shareholders.

This is a symbiotic relationship, where companies that pay progressive dividends over many years attract dividend-seeking shareholders, and those shareholders then encourage management to continue paying a sustainable progressive dividend and to avoid actions that might put the dividend at risk (the shareholder uproar around Unilever’s attempt to buy GSK’s consumer healthcare business springs to mind).

Having said all of that, I’m wary of being too selective and limiting my investment universe too severely. The truth is that bad things can happen to even the best businesses, as was made clear by the pandemic, so I think it’s reasonable to accept the occasional dividend cut, or even a temporary suspension, as long as it’s fully reversed relatively quickly.

Having looked through the dividend records of my current and past holdings, I think the following rules of thumb strike a reasonable balance.

• Rule of thumb: Don't invest if the dividend was suspended for two or more consecutive years at any point in the last 20 years
• Rule of thumb: Don’t invest if the dividend was underwater for four or more consecutive years at any point in the last 20 years

Here are a few of my holdings as examples of how these rules can be applied in the real world.

I’ll start with Unilever, as it's a well-known progressive dividend stock.

Data source for all tables: SharePad & annual reports

The table above is taken from my dividend investing spreadsheet and it shows Unilever’s dividends (in Euro cents) going back 20 years.

The green numbers tell you how many years the dividend was underwater following a dividend cut or suspension, and the table clearly shows that Unilever’s dividend wasn’t cut or suspended at any point in the last 20 years.

That’s strong evidence that Unilever has the desire and ability to pay a progressive dividend through good times and bad, as the last 20 years include a global banking meltdown and a pandemic.

My next example holding is Legal & General, which is another popular stock among dividend investors.

The sea of green from 2014 to 2023 tells us that L&G did manage to maintain or grow its dividend through the pandemic, but the amber section from 2008 to 2010 is a warning that the dividend was cut during the financial crisis.

L&G is an insurer and asset manager, so it was materially impacted by the financial crisis and cutting the dividend to protect the overall business was an entirely reasonable and sensible response. However, if L&G was fundamentally robust and if management was truly committed to a progressive dividend, then the dividend should have been fully reinstated within a few years, and that's exactly what happened.

Having cut the dividend in 2008, it was then kept at a lower level for three years while the crisis unfolded. As soon as normality reappeared around 2011, the dividend was raised to a new record high (at which point the colour-coding turned back to green).

Three consecutive years with the dividend underwater is the most I'll accept, so although L&G's track record is imperfect, I do think it has a strong dividend culture and I am happy to have it in my portfolio.

Last and definitely least, let’s look at the previously mentioned Headlam.

The red numbers in the table immediately tell us that Headlam's dividend record has some problems.

First, we can see that like L&G, Headlam cut its dividend in 2008. That isn't a major problem because Headlam is a floorcovering distributor and carpet sales obviously fell off a cliff when the economy crashed in 2008.

However, unlike L&G, Headlam didn’t fully reinstate its dividend in 2011. Instead, it took ten years for Headlam’s dividend to exceed its 2007 peak, and that definitely is a problem, because a high-quality business with a strong dividend culture would never treat its dividend-seeking shareholders that badly.

With a track record like that, it should come as no surprise that Headlam cut its dividend as soon as the pandemic struck and, five years later, it’s still a long way below its 2018 peak.

Even worse, Headlam’s management recently suspended the dividend for two years to fund an operational improvement programme, and that means it will soon break my rule around suspended dividends. 

While suspending the dividend may be the most sensible course of action for the company, it's yet another sign that Headlam doesn't have the ability or desire to pay a progressive dividend, and that’s why it has now been removed from my portfolio (I’ll publish the usual post-sale review shortly).

Looking for above-average profitability over 20 years

As well as looking for progressive dividends over 20 years, I’ve also started looking for strong profitability over 20 years. The reason is basically the same, which is that good, bad and ugly companies can all produce strong profits during a boom, but what really differentiates quality companies from the rest is their ability to generate strong profits across the full cycle from boom to bust and back again. And if you want to look at a full cycle, you have to look back 20 years rather than ten.

I think a high net return on capital, across the cycle, is the single best indicator that a company has enduring competitive advantages, so as far as I’m concerned, if a company can’t produce high returns on capital across the cycle, then it isn’t a quality company and I don’t want to invest in it.

Previously, I looked for strong average net returns on capital over ten years, with a minimum hurdle rate of 7%. That was a good place to start, but I’ve always had pushback from other investors that 7% was too low. It's taken me about ten years to change my mind, but I now agree with that prognosis so I've increased my thresholds for good, okay and bad net return on capital:

• Good = 15% or more (previously 10% or more)
• Okay = 10-15% (previously 7-10%)
• Bad = Below 10% (previously below 7%)

If you look at the entire FTSE All-Share, the median net return on capital over ten years comes in at about 10%, so my okay and good buckets are both above average, which is how it should be because I'm looking for above-average businesses. Here's the associated rule of thumb: 

• Rule of thumb: Don’t invest if the ten-year average net return on capital is below 10%

In addition to looking at the most recent ten-year average, looking at 20 years of data will allow me to look at how the rolling ten-year average has evolved over the last ten years, so I’m going to replace the above rule of thumb with a more comprehensive alternative:

• Rule of thumb: Don’t invest if the rolling ten-year average net return on capital was below 10% at any point in the last ten years

Here are two quick examples, starting with Unilever.

The top section shows Unilever's net return on capital from 2004 to 2013, the middle section shows returns from 2014 to 2023 and the bottom section shows the rolling ten-year average for earnings, capital and net return on capital.

Green means good net returns on capital (above 15%) while amber means okay returns (10-15%) and, as you can see, Unilever's net ROC was good for most of the last 20 years. In fact, Unilver’s rolling ten-year average net return on capital never fell below 15% at any point in the last ten years. That is exceptional and it’s strong evidence that Unilever has some powerful competitive advantages.

Let’s wrap up by having a look at Headlam.

This table tells quite an interesting story.

During the credit bubble of the early 2000s, Headlam was riding high on the tail of the UK’s consumer spending boom, as the Changing Rooms TV show and buy-to-let investing gripped the nation. But when the credit crunch arrived around 2008, that debt-fuelled spending spree came to an end, and so did Headlam's bumper profits.

After the financial crisis, Headlam spent the next five years (2009 to 2013) generating sub-10% net returns on capital, and it only just managed to exceed that level in the more benign economic environment of 2014 to 2018. Then we had the pandemic and Headlam has struggled to generate acceptable profits ever since.

In terms of the rolling ten-year average net return on capital, it fell below 10% in 2017 (shortly before I invested) and has been below that level in six of the last seven years.

This is what I’d expect from a mediocre business with only a narrow economic moat to protect it from the slings and arrows of fortune. It isn’t what I’d expect from a high-quality business with a wide economic moat filled with piranhas and crocodiles, and this is another reason why I no longer own Headlam.

In the next instalment of this three-part series, I’ll explain the changes I've made to my valuation process, which mostly involve no longer assuming that companies will grow forever.