Financial services group Legal & General (LSE: LGEN) and utility provider SSE (LSE: SSE) both currently support dividend yields of 7%, compared to the FTSE 100 average of 4.5%. However, while both look attractive at first glance as income investments, I’d only buy one for my Stocks and Shares ISA.
Income vs growth
Utilities like SSE are generally considered to be the market’s most defensive income investments, thanks to their predictable cash flows. But SSE’s position in the market has been deteriorating over the past few years. As profits have fallen, the company has been struggling to maintain its dividend promises to investors.
For example, on a trailing 12-month basis, the stock supports a dividend yield of 6.9%. But City analysts are expecting the company to reduce its fiscal 2020 distribution by 18%, which implies SSE’s forward dividend yield is just 6%.
The payout is expected to return to growth in fiscal 2021, although management is only promising growth in line with inflation. That’s because the company doesn’t have much flexibility when it comes to how much money it can return to investors. Analysts are forecasting dividend cover of only 1.2 times for fiscal 2021.
Lack of headroom
The lack of headroom over SSE’s payout concerns me. If earnings suddenly lurch lower, or the company has to deal with a significant, unexpected capital spend, its financial cushion will be wiped out, leaving management with little choice but to cut the payout.
Legal & General’s dividend, on the other hand, looks much more secure. The payout is covered 1.8 times by earnings per share and has grown steadily over the past six years at a compound annual rate of 12%.
The City is expecting this trend to continue. Legal is one of the UK’s largest financial services firms, with operations around the world. And unlike SSE’s, its prices are not set by regulators.
This flexibility and international expansion has helped L&G grow earnings at a compound annual rate of any 15% since 2013. Over the same time frame, SSE’s earnings per share have shrunk.
A better buy
All in all, I believe Legal has much brighter growth prospects than its Footsie 100 peer, and, as a result, I reckon the stock is a much better long-term income investment.
Demand for its asset management and pension management services is booming, and this is likely to continue as the world’s population gets older and more affluent. The company’s size is one of its key competitive advantages here. That’s because customers are more likely to entrust their money to the enterprise that has the biggest, most durable balance sheet, rather than an unprofitable challenger.
As a result, unless management makes a severe mistake, Legal should continue to be one of the top choices for UK savers and investors for many decades to come — that should translate into steady dividend growth over the long term.
Based on current City projections, the stock’s dividend yield will hit 6.7% next year and shares in the company are currently changing hands at a forward P/E of 8.7.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.
Motley Fool UK 2019