Investors may love dividends, but InvestSMART analyst Graham Whitcomb warns not to put a high payout yield too far up your list of wants.
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Dividends are much loved by investors, particularly in Australia, where favourable tax treatment and corporate attitudes have almost turned them into a religion. But at InvestSMART, we’ve always cautioned against putting a high dividend yield too far up your list of wants.
For those who are unfamiliar with the term, a dividend is the distribution of a portion of a company’s earnings paid to shareholders.
Dividends are seen as a valuable source of income in your retirement as they are real cash delivered to your bank account, not a mystical earnings figure reported by the company and prone to accounting manipulations. There’s also evidence that buying a basket of stocks with above-average dividend yields tends to outperform the overall market.
But, if there’s one thing that leads investors astray more than any other, it’s a stock’s dividend yield. It’s simple to calculate – the most recent annual dividend divided by the current share price – and it has some major advantages over other measures of value.
But, focusing solely on the dividend yield is a really good way to land yourself in trouble. For one thing, the dividend yield is a historical measure. When you buy a stock, though, the only thing that matters is what will happen in future.
Let’s take this as an example. In November 2015, a member asked us a simple question – Dick Smith Electronics’ stock had halved in price and was now trading with a dividend yield of 17 per cent. Was this a buying opportunity?
We get hundreds of questions like that. In this case, we said we were sticking by our ‘Avoid’ recommendation and that investors should ignore the yield, as it was probably misleading. Two months later, Dick Smith was bankrupt. Not only did shareholders never see another dividend, they lost all their capital as well.
Dividends are also often used by directors to reflect the performance of the company and promote confidence in future performance. They are, however, just a number chosen by the directors and, of itself, says nothing about the performance of the underlying business. It’s a short hop from that to using the dividend to keep investors onside when a business is deteriorating.
That is why it is imperative that you consider multiple factors, not just dividend yield when choosing which shares to invest in for retirement income.
While Dick Smith certainly looked to be a good investment, in reality it turned out to be very different, as the dividend yield masked the underlying risk of investing in a stock – just ask those who invested in the company.
What’s more, the dividend yield is unrelated to a company’s ability to grow. If anything, a high payout ratio could indicate a company has fewer opportunities to reinvest profits into growth projects. Sometimes a falling payout ratio is a good sign if it reflects management allocating more capital to operations or acquisitions.
If you’re a retiree, however, you may be thinking, ‘‘The cruise line won’t accept paper gains when I go to buy a ticket; they want cash. And that takes a dividend’’.
It may seem counterintuitive, but buying a high-quality, growing company with a modest dividend yield could still be your best option.
We recommended members buy Hansen Technologies in October 2015 when it had an unassuming dividend yield of four per cent. What we liked about the company, however, was that it was retaining earnings each year and using those funds to buy undervalued competitors and grow the business. It was money well spent; earnings have risen 60 per cent since we bought the stock.
Going back to 2015, let’s say that to fund your retirement you needed a seven per cent yield. You had two options: find a stock that pays seven per cent – and probably carries significant business risk if it trades at that price – or you could accept Hansen’s four per cent yield and then sell three per cent of your holding each year. Either way, you’re getting your seven per cent cash in the bank.
If you had followed the latter method, your Hansen shareholding would have shrunk by around 7.5 per cent since then, but the growth in intrinsic value per share (thanks to the 60 per cent earnings growth) has more than offset the declining number of shares you own. In fact, Hansen’s share price has almost tripled over that time. Not only did you get your seven per cent yield, you got bumper capital growth too.
As Hansen and Dick Smith demonstrate, finding hidden gems and avoiding dividend traps is a much better strategy than blindly investing in high-yield stocks.
Find more information on InvestSMART here. And stay tuned for InvestSMART’s next article, which will explain how Labor’s dividend imputation proposal will affect older Australians.
Author: Graham Whitcomb, Senior Analyst at InvestSMART.
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