For investors that want regular returns from their investments, a well researched dividend stock strategy could be an ideal solution. Yet, in a market where headlines are dominated by glamorous growth stock stories – with plenty of upside but no immediate income – knowing how and where to look for the best and most reliable yielding shares presents its own set of challenges.
Buying stocks that pay regular dividends is an investment approach that’s as old as the market – but current low interest rates and depressed bond yields are making it an increasingly attractive prospect for some. In tandem, dividend payouts from UK listed corporates continues to grow. In the first quarter of 2012 companies increasing payouts outnumbered those cutting by 3.8:1 – but that was down slightly on the 4.1:1 for 2011 overall.
That said, individual investors are frequently divided on whether the most profitable returns are achieved from dividend stocks or capital growth. Indeed, with average stock holding periods among private stock pickers estimated to be around eight months, it is clear that, at least in part, many investing strategies are more concerned with value gain than long term dividend returns. In a sense this appears counterintuitive to some market stats. Two years ago, James Montier at US investment firm GMO, wrote a paper insisting that: “…to those with an attention span measured in longer than milliseconds – who are few and far between, to judge from today’s markets – dividends are a vital element of return.” He claimed that, looking at the US market since 1871, on a one-year time horizon, nearly 80 percent of the return has been generated by fluctuations in valuation. However, over five years, dividend yield and dividend growth account for almost 80 percent of the return.
For dividend virgins, here are some of the basic metrics (and their potential pitfalls) that are required when weighing the investment case for a yielding stock.
1. Dividend Yield
In simple terms, the dividend yield measures how much a company has paid out in dividends over the past year relative to its share price (historic annual dividend per share divided by the current share price as a percentage). A forecast yield can also be established by using consensus estimates from analysts.
High yields are obviously a head-turner for dividend hunters and they tend to be dominated by some of the largest and most prestigious companies in the market – the top three are currently Man Group, Resolution and Aviva. Indeed, the Dividend Dogs of the FTSE stock selection screen has delivered strong returns simply by trawling the market for the top ten yielders and then chopping and changing them once a year.
A word of warning however is that high dividend yields can also be a sign that a stock is underpriced or in trouble and that future dividends could be cut. Likewise, a low dividend yield could signal that a stock is overpriced or that future dividends may be higher.
So, on yield alone, investors are exposed to the vagaries of the market and the occasional disasters that befall companies and sectors. For instance, back in September 2008 Lloyds Banking Group was boasting a head-turning yield of around 8 percent. Investment commentators were amusing themselves over the fact that the banking giant’s shares offered a stronger return than a Lloyds TSB internet saver account. However, the banking collapse that ensued was immediately felt Lloyds’ investors – and those dividend payments still haven’t been properly restarted.
2. Dividend Cover
In the toolkit of metrics available to track a company’s dividend performance, Dividend Cover is vital. By dividing the earnings per share by the dividend per share, investors can get a fix on how much a company is paying to shareholders against the cushion of cash it keeps in reserve to ensure that earnings are not compromised. Plainly this is important, because a company that is consistently distributing more cash than it either: A) has, or B) needs, could eventually hit problems. In the States, a more common way of calculating this involves flipping the equation – known as the Payout Ratio – but it amounts to the same thing. Dividend Cover of less than 1.5 may indicate a danger of a dividend cut while more than 2 is typically viewed as healthy.
Companies occasionally make reference to Dividend Cover in their preliminary results or annual reports but to get a jump on a stock’s financial health it could be worth applying another strong accountancy filter known as the Piotroski F-Score. This nine-point accounting test should reveal any areas of concern or, in turn, substantiate the reasons why the stock is a decent bet.
3. Dividend Growth
Tracking the number of years that a company has grown its dividend sounds like a rather obvious gauge for testing its commitment to a progressive dividend strategy and financial stability – and it is. However, consistent Dividend Growth – or the Dividend Growth Streak – is particularly important to a band of stock-pickers known as Dividend Growth Investors, who put greater emphasis on finding companies that look like they can increase dividends over the long term. Who wouldn’t want that? Well, there is a nuance…
Investors keen to squeeze the highest dividends possible for their cash – perhaps with a view to achieving immediate income – will naturally gravitate towards high yielding stocks. Dividend Growth Investors meanwhile, are more concerned with the longer term and achieving regular (and inflation beating) payouts and likely capital growth. The strategy interprets the past – dividend growth and/or cuts – to make a prediction about future dividend growth.
4. Net Payout Yield
As the name suggests, the Net Payout Yield is an indicator that takes share buybacks into consideration when dealing with dividend returns. Investors tend to be divided on whether dividends are better than buybacks (when a company buys its own stock in the market, thus theoretically boosting earnings per share). However, in cases where both are happening, analysts argue that it can be worth working up the numbers to see what the combined return is.
The method was first proposed in a 2004 paper by Boudoukh, Michaely, Richardson and Roberts, who found that combining the effects of dividends and buybacks (and any share issuances) offered superior returns than simply tracking dividends. Of note, they applied the approach to the Dogs of the Dow trading strategy and managed to produce better returns than the standard formula.
5. Dividend Per Share & Total Shareholder Return
As we’ve just seen, the Net Payout Ratio bundles together the effects of shareholder returns from either dividends or buybacks. By comparison, Total Shareholder Return is adds the dividend per share to the annual capital gain/loss of a stock – with the dividends reinvested. It is expressed as a percentage change over time and is most useful when measuring the performance of a stock over time. This metric is not only a nod to Dividend Growth Investors, who typically reinvest dividends over the long term, but it also highlights one of the most significant advantages (and risks) associated with dividend strategies – compound gains (and the risk of not reinvesting).
From gurufocus.com
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Dividends Still Don't Lie: The Truth About Investing in Blue Chip Stocks and Winning in the Stock Market
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