Reliable dividends are the cornerstone of a defensive, income-focused portfolio. But what’s the best way to find these shares, and just how reliable are they?
The first step to finding shares from companies that can pay a reliable dividend in the future is pretty straightforward: Look for companies that already have a long and unbroken history of dividend payments in the past, backed up by consistent profits.
Searching for reliable dividends
Unfortunately, a reliable dividend is a relative term rather than an absolute one. That’s because you can never be entirely sure that a company’s dividend won’t be cut or suspended altogether.
The banking crisis provides us with a good example of this. In that crisis, a whole group of companies (the banks) that were thought to be safe dividend payers turned out not to be quite so safe. Many of them suspended their dividends, in some cases for several years (and still counting).
Although you can never be sure of the future, there are things that you can look for in a company that will improve your chances of receiving a reliable dividend income.
The first thing to look for is an unbroken track record of dividend payments in the past. If you want steady and reliable dividend payments in the future, then it makes sense to look for steady and reliable dividend payments in the past.
An unbroken record of dividend payments over at least a decade is a high hurdle for many companies, but it’s a necessary one, in my opinion.
I think that if a company misses its dividend payments for a year, it’s either a risky business or it has a management team that a) doesn’t care about shareholders or b) doesn’t know how to manage the company’s cash flows effectively.
In either case, it’s not a company that should be added to a high-yield, low-risk portfolio.
And why should you look at dividends going back ten years into the past? It’s because defensive value investing is not about rapidly trading one company for another, buying and selling within a few short months. It is a strategy for long-term investors. As a long-term investor rather than a short-term speculator, your investments are more likely to be held for years, not months. It could be just one or two years, but it could also be five or ten years.
To have any faith that a company can pay dividends in every one of the next ten years, there must be proof that it has already done so in the past.
Don’t forget about reliable profits
In theory, the value of a share is the discounted value of the cash that it will pay out in future. However, measuring dividends alone gives only a limited and incomplete picture of how the company has performed in the past.
In the long run, dividends are paid out of profits, and so the next step is to look at the company’s profits (otherwise known as earnings, depending on exactly what is included and what is excluded).
There are problems with earnings, though. For example, they can be manipulated, and clever accountants can tweak them to produce results that the company’s management wants investors to see. This is a problem, but it’s not so much of a problem if we draw our focus away from last year’s earnings and look, much as we did with dividends, at the last ten years instead.
Over a longer period of time, it’s much less likely that systematic “fiddling” of earnings will stay undiscovered. Profits can be moved from this year to that or stretched to boost the company’s shares, but eventually, a more accurate picture emerges.
Ideally, a company will have made a profit in every year over the past decade. However, for me, this isn’t a hard rule, and I won’t automatically exclude a company just because it made a loss.
The truth is that even the best companies can sometimes make a loss. Perhaps a big project flops or some other issue blows up in the company’s face, and for a single year, the accounts show a loss. But if the company can maintain its dividend, and if the core business isn’t at significant risk, then a loss in one year here or there isn’t the end of the world.
So rather than ruling out companies that make a loss, I would suggest just counting how many times a company has made a profit in the last ten years. If a company made a profit in 10 years out of 10, then that’s good. If there were nine years of profit, then that’s not quite so good but is still better than average. If there were only three or four years of profit out of 10, then that’s a different matter; the company is unlikely to be up to scratch.
But it’s a relative measure rather than an absolute one. I don’t like to exclude a company on a given number of losses, although, of course, you could easily choose to drop companies that have had more than, say, two or three losing years in the last decade.
Some people might baulk at the idea of having to dig through 10 years of financial history for any investment, but it really isn’t that hard, and the data is easily available online these days.
You have to remember that defensive value investing, or any sort of investing for that matter, is a long-term strategy. You should think in terms of years and decades, not weeks and months. You could very easily end up owning a company for ten years or more. So if an investment might last for ten years, I think it’s only sensible to look back and see how the company did over the previous ten years.
Hi John
Is it possible to examine the various cash positions of the company in order establish whether the company is able to afford the dividend on an ongoing basis ?
Personally I find the various cash metrics a bit more confusing that the notion of profit but as I understand it whereas “profits are opinion” , cash has to be there. My comprehension of accounts is not deep.
Regards
Ken
Hi Ken, yes it’s possible to examine cash flows through a business. Cash is generally a more reliable measure than profits, and I’m going to post something next week about cash, I just couldn’t fit it into this article within a reasonable blog-post word limit.
Cash is still pretty tricky though. In most companies it’s surprisingly volatile (or surprising to me anyway), so I think it’s something that still requires a multi-year view. I tend to look at free-cash dividend cover over a decade, and not worry so much as to whether or not the dividend is covered by spare cash in the current year. As long as the company has a reasonable cash buffer in the bank the ups and downs of a year or two are less important than the long-term ability of the company to generate more spare cash than it pays in dividends.
You can find free cash (or net cash flow minus capital expenditure) on most investment web sites like Morningstar etc.
Hi John , Many thanks , I will be interested in what you have to say. I find the different cash flow “types” often a little bewildering whereas I suspect it is quite a simple concept.
How do you calculate what dividend yield you are receiving? I purchased Tesco shares at £3 and now they are trading at £3.50 aoprox. Should I use the price I paid for Tesco shares or the current market value?
Hi Suraj, I always use the current share price because that’s the current cash value of the investment. So if I buy 1 share for £1 and it pays a 5p dividend then I have a 5% yield. But if the share price goes to £2 then I’m only getting a 2.5% yield on that £2. So if I could find some other shares that were trading at £1 with a 5p dividend I could buy 2 of them for a total of £2 (by selling my one share that I own which is valued at £2) and then I’d get a 10p dividend (5p from each share), which is a 5% yield and twice what I was getting before.
It’s nice to keep track of the current yield relative to purchase price, but for buying and selling it’s usually better to use the current price.
Hi John,
Isn’t the simple solution for lazy investors to invest in a dividend fund which in turn invests in dividend paying stocks and does all the hard work for you? Or is there a good reason why one should avoid dividend funds?
I have invested in dividend funds for the last 8 years or so and the average return (dividend plus stock price increase) has been about 8%.
Hi Daniel,
I guess it depends on a few things. If the investor wants to have control over the exact companies that they invest in, then they have to buy individual shares rather than a fund. If the investor doesn’t care about the exact companies they they could use a fund, but it would depend on what you mean by a ‘dividend fund’.
If you mean a mechanical ETF that just buys the top 30 yielders from the FTSE 100 (or whatever) then I don’t think that’s the best way to do it. Mebane Faber’s book “Shareholder Yield” shows that cash can return in three main ways – dividends, share buybacks and debt repayment. The dividend funds only capture one of those forms of cash return.
If on the other hand you’re talking about an income focused, actively managed fund like an investment trust, then that would probably be my preferred ‘lazy investor’ route because the manager of the investment trust can smooth out the fund’s income as I’ve described in this post.
Your returns of 8% sound about average too (in other words, perfectly reasonable), as in the long-run equity returns have been about 5% above inflation, and I’d guess that inflation has been around 3% over the past 8 years or so.
Daniel
Vanguard UK Equity Income could be the answer to your question. It did beat lots of active equity funds over the three year, including Neil Woodford’s funds.
Investing in high yielding equities is an anomaly well researched by the academics. Passive investment frees your time from doing research leaving you the time to play golf. Not to say that takes the emotions away, falling in loves with stocks, selling to early, etc.
Hi John,
I am a MBA Student (in Sri Lanka) working on a assignement where I have to advise a Local (Sri Lankan) to invest in UK retail sector.
My University is University of Bolton, UK.
We ask the investor “do you want capital growth or income growth? for which he says “I want it all to grow”‘ in the assignment.
Could you please assist me with this………according to some articles I read, both capital and income growth is not possible if you invest in shares……..
DO you thin you can guide me please
Thanks & Regards
Roshinie
Hi Roshinie, I’ll send you an email.