There are many criteria I consider when making an investment in a stock. Among them is the price relative to historical value; does it look cheap, or is it at an ‘all-time high’? In theory, if I believe a company to be solid, short-term fluctuations in price are meaningless, so a falling value only encourages me to top up my holdings. By doing this, I drive up the yield, or return, on that stock. But why do I care so much about dividends?
Dividends and buy-backs are a big factor in determining my thoughts on a stock. By pursuing sustainable dividends (preferably those which grow as well), I believe I am helping to build a nest egg which will help to support the lifestyle choices I want to make and provide a supplementary income which will protect me from unforeseen expenses or the loss of my main source of income.
World growth hasn’t exactly rocketed over the last few years, with several commentators pointing out that the economic situation in many Western countries is stagnant. This situation has led to a massively reduced market of dividend-paying opportunities, with more and more money chasing a shrinking pool of investments.
Are the Dividends sustainable?
This drive for yield risks companies succumbing to short-term thinking, prioritising dividends over reinvestment to protect share prices. If dividends are prioritised in this way, companies may find themselves with unsustainable payouts, creating a source of risk for investors due to potential cuts.
Historically, UK companies paid out 50% of their profits in dividends, with the remainder being retained or reinvested in the business. More recently, UK companies have paid out ever greater proportions of their revenue in dividends, leaving nothing to reinvest in future growth opportunities.
Why is this happening?
Global companies have had a tough time growing, or in many cases even sustaining, profit levels since the financial crash of 2007/8. Falling commodity prices, government austerity and weakened consumer demand have led corporate earnings growth to fall around the world.
Despite this, corporate dividends continue to grow, creating serious risk of future cuts to dividend payments. The good news is that these are abstract trends from across entire economies. This means that there are still plenty of opportunities present in the market for those that care about dividends. The fear I have is whether companies are storing up an enormous headache for future generations by systemically underinvesting in staff and capital. Western countries have long faced arduous challenges with rising costs, populations and falling productivity – surely we don’t want our companies going the same way?
Dividend payments are important – if I put capital into a business, I expect a return on it. If I can’t get one, I might as well just spend the money buying a new suit or going out for dinner. As an investor though, I recognise that it’s the long-term sustainability of those dividends that really matters. After all, if the dividends are cut and the share price tanks, not only does my income suffer as a result, but my capital values drops as well!
Conclusion
I still consider the acquisition of income paying assets to be in my best interests. Dividend-paying stocks can be a great asset to hold to generate a passive income to support travel, fine dining and a comfortable lifestyle. Many parts of the world still retain a conservative approach to dividend payouts, with many individual companies still presenting great investment opportunities.
When examining a dividend yield, an investor should be sure to look at payouts as part of the entire picture. Are revenues growing, or shrinking? How much debt does the company hold? Is the company in a flourishing or declining market?
By asking questions such as these, an investor is taking steps to prevent themselves from buying into an unsustainable dividend policy.