FTSE 350 income: screening for top dividend growth opportunities

In my piece last week I showed how a simple screen might be a useful tool to find sustainable high yield stocks in the FTSE 350.

This week I want to approach income from the perspective of strong growth rather than yield. So I’ve created an alternative screen that looks for stocks with strong dividend growth characteristics.

Why would I consider this approach? For me, dividend growth investments fall into two possible categories (sometimes both):

Quality growth stocks: rapid, well-supported dividend growth can be an indicator of a small/mid-cap quality business that’s growing fast. In this scenario, the company’s share price will often rise at a similar or even greater rate than its dividend.

Contemporary examples of this might include Tatton Asset Management (LON:TAM) or Jet2 (LON:JET2). These companies have five-year average dividend growth rates of 13.8% and 7.6% respectively. Both have been multibaggers over the last 10 years:

Cash multibaggers: over longer periods, successful dividend growth investments can reach a point where the cash income received from the shares exceeds the original investment.

In other words, the investment will deliver multibagger returns in cash, not just through share price gains.

The most famous example of this is probably Warren Buffett’s stake in Coca-Cola Co (NYQ:KO). Buffett’s company Berkshire Hathaway owns 400m shares that originally cost the firm about $1.3bn. That’s equivalent to an average cost price of about $3.25 per share.

Coca-Cola’s dividend currently stands at $1.89 per share, according to Stockopedia. That gives Buffett’s shares a yield on cost of 58%.

In other words, Berkshire Hathaway doubles its original Coca-Cola investment in cash income alone every two years. That’s without factoring in share price growth:

A word of warning! Warren Buffett has owned Coca-Cola shares since the dawn of time 1988. Investing in potential dividend compounders is a long-term strategy that is only likely to work well with high quality businesses. Essentially, this is an income variation of the compounding quality approach.

Over shorter periods, the income received from dividend growth stocks may be significantly less than the cash payouts from sluggish high yielders.

I’ll return to this theme in the final article of this series, when I’ll consider some of the factors involved in choosing between dividend growth and high yield.

In the remainder of this article, I want to discuss my income growth screen and consider some possible examples of interesting dividend growth shares.

FTSE 350 dividend growth screen

Screening is always a balance between being too restrictive and insufficiently selective. I tend to err on the side of easing my rules and doing additional manual checks to filter out unsuitable candidates.

Screens are meant to be a list of ideas for further research, so I think it makes sense to accept a little extra work in return for a more varied list of possible opportunities.

In this screen, I’ve tried to find companies with above-average profitability, a track record of earnings and dividend growth and a sustainable dividend.

The growth element of this screen means that it makes more sense to consider smaller companies than it did for the high yield screen.

As a result, I’ve set the minimum market cap at £300m to match the smallest companies in the FTSE 250. In reality, I think it might be worth going a little lower still.

In terms of absolute dividend yield, I’ve set a minimum forecast yield of 1%.This is obviously too low for any investor seeking a worthwhile income. But I think it can make sense where dividend growth is serving as a proxy for strong underlying business growth.

As always, it’s important that all investors understand what they’re trying to achieve and DYOR. There’s no one-size-fits-all solution.

With that said, here’s a snapshot of the screening rules I’ve used:

You can see and edit this screen here.

The screen returns 32 shares at the time of writing. Here’s a snapshot of those with a StockRank of 80 or higher:

In the remainder of this article, I’ll take a look at a few of these that look interesting to me at the moment.

Jet2 (LON:JET2)

As an investor, I’m a big admirer of this well-run travel business, which operates a budget airline and package holiday business. Having been a customer a few times, my experience is that the service is also hard to fault.

The company’s growth record is deeply impressive, in my view. Revenue has risen at a CAGR of 16% since 2019, while earnings have grown by an average of 13% per year over the same period.

Jet2’s dividend has risen by 7.6% CAGR since 2019 despite the pandemic. Since 2014, the payout has grown at a CAGR of 18%:

The stock’s quality metrics are surprisingly good for a business of this kind:

Having said all of that, a cyclical travel business and a capital-intensive airline do not obviously fit the sustainable quality growth profile I’m looking for.

Is Jet2 the exception to the historical rule that airline stocks rarely make good long-term investments? That’s an individual decision.

However, the shares are rated very highly by Stockopedia’s algorithms at the moment, perhaps suggesting that the current positive run has further to go.

The consensus outlook for earnings is also fairly positive:

Alternative UK consumer stock: for a more conservative and higher-yielding UK consumer stock, Associated British Foods (LON:ABF) could be worth considering. Megan reviewed this family-controlled conglomerate in the DSMR recently – read her thoughts here.

Qinetiq (LON:QQ.) 

FTSE 250 defence group Qinetiq has become a little more pricey since Paul took a positive view of the stock in May.

However, the company has also benefited from several broker upgrades this year and is a beneficiary of the broader strength in the European and US defence sectors.

Qinetiq’s dividend has grown at a CAGR of 6% over the last decade, a rate brokers expect the company to maintain over the next couple of years:

While the yield is low, the payout is covered more than 3.5x by earnings and the balance sheet looks fine to me, with quite modest net debt. Cash generation appears to be quite good, so I wonder if there’s scope for more generous payouts as the business expands.

One possible concern might be that profitability has been somewhat inconsistent in recent years:

However, forecasts suggest a gradual recovery in margins from FY25 and I don’t think the shares look too expensive for a business of this kind:

The StockRanks have a broadly favourable view, but flag up some weakness in value.

This score reflects the stock’s High Flyer style – further gains are possible but any disappointment could trigger a sharp de-rating. I’m inclined to remain positive though, given the broader macro backdrop and US exposure of this business.

Alternative Industrial stock: an alternative choice from the Industrial sector might be distribution group Bunzl (LON:BNZL). This business supplies a vast range of goods such as cleaning and safety products to customers all over the world.

It’s a remarkably well-run and solid business in my view, with strong competitive advantages. The dividend record is outstanding, with a 10-year CAGR of 7.4% and 30 years of unbroken growth:

Bunzl shares have risen by 670% over the last 20 years, in a nice example of how long-term dividend growth can be reflected in share price growth.

Gamma Communications (LON:GAMA)

This business communications technology group is not a company I’ve paid much attention to until recently, but I wonder if this has been a missed opportunity.

Gamma boasts an excellent long-term profit growth record and some very respectable quality metrics:

The firm’s share price has risen by 625% since IPO in 2014…

… a record that’s been reflected in a dividend growth CAGR of 12.6% per year. Payouts have been made every year since 2015, its first full year of listing:

The dividend yield is low, at 1.2%. But again, I see this as an indicator of underlying business growth, with the potential for more generous payouts in the future (the balance sheet has net cash).

Broker forecasts suggest the historic double-digit dividend growth rate may be maintained:

Again, a High Flyer styling is a reminder of the risk of a sharp correction if growth does disappoint. However, broker earnings have trended higher this year and the outlook seems fairly positive.

If Gamma’s profitability and growth rate can be maintained, I suspect the shares could easily grow into the current valuation.

Gamma Communications could be worth further research, in my view.

Alternative Technology stocks: for a different way to play the enterprise IT sector, Softcat (LON:SCT) and Computacenter (LON:CCC) (I hold) might be worth a look. Both are valued-added resellers that have successfully built service businesses on top of box-shifting operations.

Disclosure: at the time of publication, Roland owned shares in Computacenter.