Last Updated May 25, 2012
Remember the mantra from last time – income first, capital growth second, invest for the long term. With shares, income means dividends and the higher the yield the better. However, there’s more to it than that.
If you go to your favourite stock screener (or just google ‘stock screener’, there are plenty out there) and sort all the shares in the UK market by dividend yield you are probably going to get a large number of junk shares. That’s because the quoted dividend yield is based on the last dividend that was paid out, not the one that’s going to be paid out next; and it’s what gets paid out over the next few years that really matters.
While writing this I ran a quick screen and the highest dividend yield is for a company called AssetCo at a whopping 130%. If that dividend were sustainable it would mean that for each pound invested you’d get a cash return of £1.30 each year, while still owning the original shares.
The odds of a 130% dividend actually getting paid out have got to be pretty close to zero and that’s a big part of why the quoted yield may be so high. The company might be in all sorts of trouble (perhaps – I haven’t looked) and it’s doubtful that it would fit the long term criteria above.
It’s quality income first
So there’s more to actually getting a good yield than just picking shares with a high quoted yield. What we’re after is a high sustainable dividend yield. Sustainability is one of the central themes of sound investing.
Using a property market analogy, a super high yield share is like a house that you can buy for say £20,000 (assuming you bought the place outright) that might yield £5,000 cash profit once you’ve filled it with students, in other words a cash yield of 25%. What sort of a house are you going to get for that money? At such a low price the house is likely to be a basket case which will either fall down or need so much maintenance that you’re £5,000 profit will need to be put back into the place to fix the roof and anything else that goes wrong. Of course if it falls down you might loose your initial investment altogether.
In many ways shares are the same which is why it’s better to look for high yields but only in solid, stable companies where the odds of significant trouble are relatively small.
How to find solid, stable companies
One place to start is with the company’s history. Various studies have shown that companies with long histories of uninterrupted dividend records tend to have more dependable dividend payouts in the future.
Of course nothing is certain, but when I’m looking for a stable income the first thing I look for is a long history of uninterrupted dividends. In fact I’ll typically take it a step further and rule out companies where the dividend has been reduced at any point in the last decade.
I also like the company’s sales and earnings to have had a long and steady history and so any losses in the last 10 years is a definite no-no.
Whilst they aren’t as important as a steady dividend record this kind of added stability gives me confidence that the company is likely to be around in 5 or 10 years, which is a reasonable timeframe to view any investment where the price can be volatile.
So now we have two main criteria:
1. A high dividend yield and
2. Sales, earnings and dividends which have all been positive and stable for a long time.
Next time I’ll look at most investor’s favourite topic, growth.