Dividend-paying stocks remain an attractive income investment, having historically outperformed other investments with less volatility.
Moreover, dividend yield and growth represent the majority of total equity returns over the long term.
A breakdown of average equity returns in the past 45 years shows that the returns arising from dividend payouts account for more than two-thirds of the total gains for an investor, while capital gains represent less than one-third.
Dividend yield is obviously a key factor in selecting stocks, but when looking at yields a strong and sustainable dividend should be sought, not the highest payout.
Buying companies just because the yield is high is one of the biggest mistakes in dividend investing. These stocks can become ‘value traps’ – stocks that lure investors with high yields, but turn out not to be good investments.
Investors need to understand why a company’s dividend yield is high.
A payout may be large simply because the business generates a lot of cashflow and pays a large part of its cash back to shareholders.
On the other hand, the dividend yield may be high because the stock price is depressed.
In such cases, investors should understand why this is the case.
An effective investment approach to dividend investing combines quantitative screening with fundamental analysis.
This enables the investor to identify stocks that trade below intrinsic values and that can sustain their payouts in the future.
Earnings, cashflow, balance sheet strength, long-term business potential and strength of management are all crucial fundamentals.
| DIVIDENDSIN NUMBERS |
$1.2trn Total global dividends in 2015, up 9.9 per cent 14.1% The percentage by which US companies increased payouts to shareholders in 2015 60% Dividend payments have increased by 60 per cent since 2009 Source: Henderson Global Dividend Index |
In the search for stocks offering a dividend yield, investors should look for those with more than their combined sector medians and where the company has the potential to increase its payouts.
To provide a solid understanding of future potential, an in-depth assessment of the dividend’s sustainability going forward is essential.
Such an assessment should include the expected dividend yield, coverage, growth and the company’s payout policy.
Dividend expectations depend to a large extent on a company’s earnings potential.
As such, earnings growth and revisions for the coming years should be monitored and analysed.
Dividend sustainability also depends on the firm’s capital structure, including interest coverage and credit rating developments.
Investors are currently seeing more attractively valued companies in Europe compared with the US.
In terms of sectors, banks and energy firms are preferable at present.
Financials stocks in Europe combine attractive valuations with high and growing dividend yields and offer direct exposure to the consumption recovery in Europe, further spurred by the recent stimulus actions by the European Central Bank.
Meanwhile, quality growth industries such as healthcare, consumer staples and consumer discretionary have never been so expensive and could start to lose their leadership.
