7 golden rules of dividend investing

Getting passive dividend income every month is a dream come true for many, particularly if that income more than offsets one's expenses.

It is like achieving the "Holy Grail" of dividend investing. All of our talks and dream about it but alas, few ever seem to accomplish it.

DIVIDEND YIELD

A counter's total return consists of 2 parts:

1. Returns from dividends
2. Returns from price appreciation

The importance of dividend return often gets ignored because price appreciation garners much more attention during bull market periods.

However, over a longer-term horizon, dividends account for a stable and significant part of the equity premium.

Going back to 1960, 82 per cent of the total return of the S&P500 Index can be attributed to reinvested dividends and the power of compounding.

As we are coming towards the tail-end of the business-cycle with a recession now a potential concern among many developed nations, returns from capital appreciation will likely play second fiddle to that of dividend returns.

DIVIDEND SAFETY

Consistency in dividend payments or what we termed as dividend safety is essential to the success of a dividend investment strategy. Chasing the highest yielding stock is often a key investment fallacy undertaken by newbie dividend investors.

Sustainability of dividend payments should be given higher priority because companies that pay out a significant share of their earnings in dividends might:

1. not be able to sustain such a dividend trend which implies that future dividend payment might fall
2. they are not reinvesting back into their business to further grow the top-line.

When it comes to dividend safety, strong balance sheets and robust underlying economics of the business, coupled with low or moderate pay-out ratio are key indicators that one should be aware of.

DIVIDEND GROWTH

While dividends are an important component of a counter's total returns, it has been proven that companies that consistently grow their dividend payments have outperformed dividend payers lacking dividend growth by as much as 34 per cent, according to studies done by research firm Ned Davis.

The combination of a high dividend yields today and even higher dividend payments tomorrow can serve as a potent tonic for one's dividend investment portfolio.

PUTTING THE PIECES TOGETHER TO COMPLETE THE PUZZLE

A quality dividend investment strategy will consider each factor that influences the performance of dividend-paying companies.

We develop the following tried-and-tested rules for dividend stock investing. We have broken down the most important practices that all dividend investors should know and follow and narrowed down to a list of 7 rules designed to help you navigate and overcome the pitfalls of dividend investing.

GOLDEN RULE: INVEST IN STOCKS WITH TRACK RECORDS OF DIVIDEND GROWTH

[[nid:456756]]

Quality beats Quantity. You want to be invested in stocks that not only spot a higher-than-average yield but one that has shown consistency in increasing their annual dividend payments.

Before investing in any dividend-paying stock, be sure to check its dividend history first. Make sure the company has not cut its dividend payment recently. Another shortfall is stagnant dividend payments, one where the company has not increased its dividend payments for a long-time.

In general, dividend investors should look for dividend stocks with a dividend CAGR of 3 per cent over the past 5 years.

BARGAIN RULE: INVEST IN STOCKS WITH A HIGHER-THAN-AVERAGE YIELD TO MAXIMIZE CASH FLOW FROM YOUR INVESTMENTS

Everyone loves a good bargain. If a stock passes the first rule, which is an up-trending dividend payment profile, then one should look at choosing a counter with a higher-than-average dividend yield payment. The current yield of the STI Index is approx. 3.7 per cent while that of the S&P500 is approx. 2.0 per cent.

As a simple rule of thumb, we will classify a stock with a yield in excess of 4 per cent as one that is high-yielding in nature. High yielding dividend stocks have typically outperformed lower-yielding dividend stocks and non-dividend payers as well as dividend cutters by significant amounts, as illustrated in the table below, based on data from Ned Davis Research and Hartford Funds, illustrating the performances from 1972-2018.

The best performers, however, have been dividend growers, that is why they sit atop as our Rule #1.

A word of caution. Do not simply go for the highest yielding stocks (more on that in Rule #3). These stocks might be paying out too much in dividends and retaining too little to grow their business.

DIVIDEND-TRAP RULE: INVEST IN STOCKS THAT DO NOT HAVE HIGH PAY-OUT RATIOS

Simply chasing after high yield counters that cannot sustain their dividend payments is a common investing mistake that rookie investors make. Such stocks are Dividend traps, meaning that their high yield is nothing more than temporary bait to lure investors seeking high yield. However, that high-yield is often an illusion, one that is not sustainable.

[[nid:469472]]

One simple way of checking of a dividend payment is sustainable is by looking at the counter's payout ratio. This refers to the percentage of its net income the company pays out in dividends. If a company earned $5/share and paid out $3/share in dividends, it would have a Payout Ratio of 60 per cent.

A Payout Ratio below 60 per cent is typically within an acceptable range for a mature business that does not have to reinvest a large chunk of its earnings back for growth.

A Payout Ratio of 75 per cent or higher could be difficult to sustain if a company experiences a prolonged drop in earnings

There are however some exceptions to this rule. For example, REITs typically have Payout ratios in excess of 90 per cent. Another example is when the economy is in a deep recession, a company's earnings might be temporarily hit, which pushes their Payout ratio unusually high. As long as the company has a strong cash buffer with no structural impact to its core business profile, then it should not have too much problem maintaining its current dividend payment.

SUSTAINABILITY RULE: INVEST IN STOCKS THAT ARE SHOWING AN UPTREND IN REVENUE GROWTH

It is not sustainable for a counter to have a growing dividend payment profile but yet demonstrate sustained weakness in its core business revenue.

[[nid:470290]]

A company's operational growth is what drives its ability to pay higher dividends. Revenue growth is often the very first requisite towards generating sustained higher earnings and consequently the ability to pay more dividends.

While a company's cost-cutting efforts can lead to an improvement in its bottom-line, there is limited scope for cost-cutting initiatives to continuously drive earnings improvement without a corresponding rise in revenue.

One point to note. Competition among companies has intensified due to globalisation and the rapid pace of innovation. Even a blue-chip today with a fantastic track record of consistent revenue, earnings and dividend growth might cease to be relevant in a changing structural environment.

It's no longer enough to just buy a blue-chip dividend payer and not look at it for the next 30 years and assume that everything will work out fine. Having a laissez-faire approach might work in the past but could be a recipe for disaster in today's rapidly changing landscape.

CASH IS KING RULE: INVEST IN DIVIDEND STOCKS THAT ARE GENERATING CONSISTENT CASH FLOW

The best dividend stocks are often those that demonstrate the ability to generate consistent cash flow. It is the actual cash that is used for dividend payments, not just the fact that a company is generating higher revenue or earnings. Higher revenue or earnings generation that is not accompanied by a corresponding increase in cash flow over time is a potential red flag and a clear signal that dividend growth is not sustainable.

Also, look out for companies that might have huge capital expenditure requirements ahead which might stifle their ability to pay higher dividends.

SLEEP-TIGHT RULE: INVEST IN DIVIDEND STOCKS THAT ARE NOT OVERLY VOLATILE

Stocks with lower volatility have a history of outperforming higher volatility stocks in all business cycles. Dividend stocks by nature tend to exhibit lower volatility.

Their businesses are more mature and stable vs. growth stocks (non-dividend payers) and hence lower the probability of "negative/positive earnings surprises" that tends to escalate their stock price volatility. This runs counter to the prevailing belief in investing that higher risks are generally rewarded with higher returns.

However, this is not a one-rule fit all scenario. There are still many high dividend stocks with high volatility aka high risk. Since risk is not rewarded, one should be selective and focus on low-risk stocks that also exhibit high and stable dividends.

TIME-TO-SELL RULE: DEVELOP A SELL STRATEGY AND STICK TO IT, CUTTING OF DIVIDEND COULD BE SEEN AS A MAJOR RED FLAG

[[nid:469167]]

Most investors focus on buying and neglect the selling. This rule is quite possibly the most important one of all. Dividend investors always need to keep in mind that engaging a "Buy and Hold" strategy does not mean "Buy and Hold and Forget, regardless of how far the stock has fallen", many times reasonably so.

Dividend investors should also develop a sell strategy in order to protect profits and minimise losses. It is time to sell when a stock is overpriced, using certain metrics like Price/Earnings ratio or when a stock has fallen significantly below your entry level (-15 per cent could be the initial threshold). In the latter's case, we suggest taking a close look at the company's statistics to assure yourself that its fundamentals have not witnessed a structural change for the worse.

Sometimes, a drop of 15 or 20 per cent could just be the effect of market gyration and not company-specific. Usually, however, such a drop, particularly in a short period of time, could indicate company-specific problems that warrant further investigation.

CONCLUSION

The 7 rules we have outlined in this article are a good foundation upon which to develop a solid dividend stock investing strategy. These are by no means complete nor are they hard and fast rules but a useful guide for dividend investors to keep in mind when building their dividend portfolio.

Investors often focus on short-term price fluctuations. However, there is plenty of evidence to illustrate that focusing on long-term dividend plays do "PAY DIVIDENDS" at the end of the day.

This article was first published in New Academy of Finance.