The prospect of receiving a dividend, be it paid quarterly, half yearly or annually on a recurring basis, seems a logical enticement for buying a particular stock. Add in the potential for that dividend stream to increase as a company performs from year to year, then that sounds like a double benefit.
A reliable, passive income that looks like a permanent stream of cash flowing into your bank account may possibly seem almost to good to be true.
Surely this is the way to build an ultimately successful portfolio?
It is, but as always, the devil is in the details.
Yes, it would be desirable for most of us would-be investors to get an income stream that could make up for a lack of capital growth, or be an addition-to.
But first of all, like most new endeavours, we must do our homework properly to find such companies and consider the ambiguity of such a task.
What are the stumbling blocks to finding a good looking company paying a good reliable dividend?
Is there more to discover than the eye can see?
What are the unintended consequences of relying on a dividend?
I will sum up first. You have got to be very careful when making such an assumption that a company will in fact pay a dividend.
I suppose the most logical way of approaching the dilemma is to ask yourself, Why should a company pay a regular dividend?
Such a question is exactly what will be discussed at Board level (the company's Board of Directors).
But here's the rub. Most companies pay some sort of dividend because the Board (yes those at the top above management and directing some wisdom and governance) have come to the simple decision (not simple mind you) that it does not need a certain amount of capital in the future to run the company. Repeating, this is not a simple decision, maybe at the best of times, but nevertheless a decision that is on the minds of most company Directors (and top management typical the CFO and CEO who will reason with the Board the merits) when they approve half year and yearly results.
What you can do is to see if there is any consistency to a company paying a dividend and to look at past behaviour.
What has happened in the last five years, for instance. I use the Yahoo Finance database to find information like this. Just bring up a five year chart on such and such a stock and you will see on the graph any dividends that have been paid. Likewise you could use the NZX website to find local information on dividends being paid for any specific stock. Or if you are interested in NZX50 companies, you can use the profiles on interest.co.nz.
Okay, you have eyed up a particular investment prospect from the above initial analysis (everything looks promising, say 5yrs in row it has paid dividends half yearly in succession) but you are still curious. Rightly so, because we've only just started on this research.
Next you should try and work out what percentage of earnings that dividend represents (and if you can, calculate free cashflow; I know it is a bit tricky at this stage of your knowledge vocabulary, but try). The reason you want to look at these metrics is because, as you'll get to understand, profitability never stays still. Change is a constant for any company.
For instance the higher the dividend versus earnings, then the higher the possible likelihood that such a dividend payment in a bad year might not be feasible.
Contrast that situation to a company that pays a low dividend relative to earnings. Here the future payment of a dividend might seem to be more secure.
You can also look at what has gone on in the last five years from both viewpoints, i.e. earnings and dividends. Can you see some correlation? Is there a pattern?
Now you want to hear the story from the horse's mouth. Read the latest company earnings result and identify what is the current declared dividend policy. These inquiries I am throwing at you are good for you, reduces naivety. The more you delve, the more you'll find and you'll be wiser for the exercise.
Most companies will in fact have a dividend policy, so see if you can find this documentation and lock it into your mind and make scribblings about the company you are focused on. I am hoping you are writing things down because this will help you build up your own picture about how you see the company in this particular instance.
A mid-term warning. Shit can happen. I mean, for whatever reason a company can all of a sudden stop paying dividends and you are left with a non-income generating asset. As you can understand this isn't in the plan. But hang in there, this happens to all us portfolio builders.
I point this abrupt possibility out because we have seen it across the board here in NZ in the last 12 to 18 months as companies have had to navigate the uncertainties of Covid-19.
But it is not all doom and gloom in such a scenario. Good companies generally do resume paying dividends after such roadblocks, so have patience and be humble. You aren't the only one feeling the bump in the road.
What you don't want to be caught up in, is a company that pays a high dividend versus earnings and at the same time carries a bucket load of debt. Debt is a killer, so try and fathom if you can from your general readings, especially that latest report, how much debt the company is carrying. There is a lot of work involved in really defining an optimal debt level, but be aware. If a company has less than a year's earnings in debt, then should be all fine, a semi no-brainer. Multiples higher, then I would be more cautious on assumptions going forward.
So don't fall into the trap of thinking that all high dividend paying companies are all strawberries and cream. Actually the best approach maybe to aim for a lower yielding company, one that maybe you think will have the possibility in paying higher dividends of the future.
Yes I am making you think as this is part of the education in analysing what companies to add to your portfolio. Build your awareness, write your thoughts down, especially ones that seem material to you.
So get going, start investing for an income stream. It's got to be good for you.
Tony Morgan has run a portfolio management business and an equity brokerage, both of which were purchased by Craig Investment Partners. He now runs a small family office that invests globally. Other articles in this series can be found here. And the profiles of all the NZX50 companies can be found here.
26 Comments
The first one that springs to mind is AFI (Australian Foundation Investment) Company. They are purposely structured in a way that delivers consistent dividends (even during recent times), so probably quite suitable for the demographic you're describing (since TDs are awful). Not financial advice! (:
Investing heavily in bonds, with current fast increasing interest rates, is NOT as conservative as it may have been in the past.
You now have to be a sophisticated investor and also be ready to take some risks if you want to invest in bonds. Moreover, risks appear to be skewed on one side, as interest rates have reached rock bottom and there is only one direction they can go now: up, especially if inflation takes hold. I am only keeping a very small percentage of my savings in bonds, as central banks have completely rigged the bond market and the interest rates normalization process, which may happen very quickly, might prove quite painful to many investors who have been bought into the fable that bonds are without risk. There is still scope for getting decent returns in bonds, but it is going to be quite tricky indeed.
I'd personally rather go for investment in shares, especially in the sectors (such as resources, energy and infrastructure) that are more inflation-resilient.
I_O,
I have been dividend orientated both personally and professionally for decades, so i agree with much of the article. "Debt is a killer". I must disagree. Where debt can enhance a company's return on capital, then it's perfectly acceptable.
In the NZ market, assuming as always that the intention is to be a long-term investor, then companies like Mainfreight, POT and F&P Healthcare are in my view, no brainers. There are others like Freightways, Skellerup, Briscoes(no debt at all) and others. I hold shares in some 30 NZ companies plus others in Australia. However, for a new and low-risk investor, I would generally suggest a portfolio of low-cost index funds.
Mainfreight and Skellerup are real gems, but the current price looks a bit on the high side. F&P Healthcare is good too, but I would not discount Ebos either. I bought quite a few MCY shares when they initially floated, and they have given me very good rewards - I am still holding them.
Tony,
" possibly to big an ask for the general new investor". Precisely. Most people have never read a balance sheet and wouldn't know what to look for, so should stick to low-cost funds while they begin to educate themselves. Investopedia is not a bad place to start.
Good article, there are companies out there that have paid dividends uninterrupted since the 1920's, no need to limit yourself to just looking at the last 5 years. Look up 'dividend aristocrats' for a list of companies that have paid and not cut dividends for 25 years, there is another list for 50 years.
Beware sometimes these records mean that companies pay dividends when they should not, just to keep the record intact.
Have a look at EPD for a ROCK solid dividend of 7.5% and some decent price appreciation potential as well. There are loads of extremely solid American companies with long track records that pay good dividends at cheap prices as everyone chasing Tesla and big tech.
Lyn's had some sketchy calls recently such as Chinese equities such as TenCent. I don't think she really understood the external issues (i.e., govt). She's also quite bullish on Russian equities. Once again, there's a lot of unknowns besides balance sheets and financial data.
On Thursdays the Herald gives a metric called t/c, which is the ratio of earnings to dividends for the NZX.
I can't understand why you would pay dividends when you owe a whole lot, surely cutting interest costs by eliminating debt is going to give shareholders a better deal by cutting out banks and bondholders.Especially considering the outlook for interest rates, it is even more important to get rid of debt while you can.Look at Apple for success.Look at our gentailers, who are borrowing huge amounts on behalf of shareholders merely to pay dividends, an illusory profit.
Obviously debt can be good for expansion, but dividends are for when you are not expanding and have no debt.
Shareholders should expect profit through overall asset appreciation, and not just dividends
A smallish co I'm a shareholder in at my prompting stopped paying dividends (which were being paid to satisfy the conventional expectation of dividends rather than any rational reason), got rid of debt, got a substantial war chest and was then able to confidently aggressively expand during times of high interest rates( throwing interest rate worries to the winds), still no debt, share price through the roof, still growing .
No, they earn massive cash flows and dividends are well covered by cash generation, EPS are reduced by huge depreciation charges from infrastructure investment, a detailed understanding of capital investment and depreciation of assets is required to properly understand it.
According to the Herald many companies are paying out 2or3 times their earnings in dividends, so are borrowing to pay dividends which seems pointless, unless it is just to appease the common irrational expectation of dividends
And depreciation xc is still a cost, you need to look at net earnings per share after depreciation, interest xc; need to cut to the chase.
Fundamentally the original point of owning shares was to receive some form of return from the company. ie. a dividend payment.
Obviously starting up, or in a period of growth one may not expect anything, or if the company had a bad year.
But for a company that has been around a while, to be paying zero/minimal dividend suggest to me they are likely overly indebted, poorly run, or on the way out (eg a combination of both)
These days I think the concept of owning a company to get a share of the profits these days is just a fantasy. Basically the sharemarket is just gambling (not to say I don't dabble).
"Fundamentally the original point of owning shares was to receive some form of return from the company. ie. a dividend payment."
The idea is to get rich through dividends and/or share price appreciation surely.
It depends on believing, that in the long run the market will always go up, for a diversified portfolio, so far this (?ponzi?) is validated long term.
We welcome your comments below. If you are not already registered, please register to comment.
Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.