UK dividends per share (DPS) forecasts have accelerated in the last few months, gaining 4% since November, while EPS estimates have remained volatile, with mid-caps leading the way. Since DPS upgrades often correspond to stock price outperformance, Morgan Stanley analysts Graham Secker and Hanyi Lim recommend screening for low payout ratios as a way to generate new ideas.

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DPS increases tend to cause stock outperformance

“Historically, stocks that have posted the strongest dividend growth have also seen the best relative price performance,” they write. “This relationship has also been present over the last three months – for example the quintile of stocks that has seen the biggest increase in 12m DPS over the last 3m has outperformed by 9.1% over the same period.”

The three-month trend is most striking in UK midcaps, but it has also seen more of a correction recently than in large caps. Small cap DPS forecasts fell off sharply in November, and while it has recovered recently there can also be more volatility than in the mid or large-cap stocks.

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It’s not just that DPS forecasts have been more consistent than EPS forecasts recently – the two diverged in November after being correlated for about 15 months. Now that DPS is moving on its own again it makes sense to give it a bigger role when deciding which stocks to invest in since it is a separate driver of stock price.

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Positioning for DPS increases

One strategy for taking advantage of the accelerating DPS forecasts is to look for Overweight rated stocks that have payout ratios that are low relative to history, because they have the most potential for DPS growth. Secker and Lim identify Hays plc (LON:HAS), Aviva plc (LON:AV), ABF, First Group, Smiths Group plc (LON:SMIN), Reed Elsevier, Intertek Group plc (LON:ITRK), Schroders plc (LON:SDR), William Hill plc (LON:WMH), LSE, SABMiller plc (LON:SAB), IHG, Croda, Stagecoach and Daily Mail as some of the stocks that investors might want to consider for their relatively low payout ratios.

Alternatively, Next, WH Smith, BHP Billiton Limited (NYSE:BHP), J D Wetherspoon plc (LON:JDW), Rightmove Plc (LON:RMV), GlaxoSmithKline plc (NYSE:GSK), Carnival, Rolls Royce, Compass and IHG all have a history of healthy buybacks, which can often a better way of returning money to shareholders.

While the correlation between DPS increases and stock outperformance holds in Europe ex-UK, Secker and Lim haven’t found a similar rise in DPS forecasts on the continent. It’s still possible to find stocks with high potential for DPS growth, but there may be fewer stocks that fit the bill.