Natural monopoly
Utility stocks are the first to come to mind when I think of defensive dividend investing, and National Grid (LSE: NG) is probably the most defensive of them all. Being a natural monopoly in a heavily regulated industry means the stock has income power.
Revenues for the company are set as an allowed return on the value of its regulated assets, and do not depend upon the volume of gas or electricity transported or commodity prices. This results in the company earning “rent-like” profits, which gives it a high degree of visibility over future cash flows.
On the downside, National Grid has very high debt levels. Net debt is nearly nine times its annual retained cash flows (ie, operating cash flows less dividends) and interest costs account for around a quarter of its operating profits, even though low interest and inflation rates have kept costs artificially low in recent years. And interest rates won’t stay low forever, with most economists still anticipating the Bank of England’s first rate hike will take place within the next 12 months.
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Valuations are on the expensive side too, with the company’s shares trading at 15.9 times forward earnings. However, given the reliability of its cash flows, National Grid can afford to pay around 70-75% of its earnings as dividends each year. This gives it a very respectable dividend yield of 4.3%, which city analysts expect will rise to 4.4% this year, and 4.6% in 2017.
More risk
SSE (LSE: SSE) is a more risky pick. Its dividend cover is expected to fall to 1.3 times this year, below its 1.5 times target, as recent volatility in commodity prices will likely weigh down on the profitability of the company’s electricity generation and gas production activities.
But with the utility company’s earnings due to return to growth via a double-digit rise next year, the company should be able to maintain its progressive dividend policy. SSE appears to be a strong income play, with its yield of 5.8% being substantially higher than the sector average. And with SSE trading on a forward P/E of just 13.0, the stock is attractively priced too.
Predictable income
Investing in the property market may not seem to be the most defensive move, but healthcare properties are an exception. Healthcare demand is non-cyclical, and the need for purpose-built modern healthcare premises continually expands with a rising and ageing population.
With more than 90% of its rental income coming from NHS-backed revenues, long lease terms and upwards-only rent review, Primary Health Properties’ (LSE: PHP) income is supported by very predictable long term cash flows. The stock doesn’t come cheap, trading at a 21% premium to its net asset value (NAV). But, with a portfolio vacancy rate of only 0.3%, at least its assets are generating income near its full potential.
From a yield perspective, the REIT is more attractive. At a share price of 106p, it currently trades at a prospective dividend yield of 4.8%.
