Last Updated February 24, 2014
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 straight forward: Look for companies that already have a long and unbroken history of dividends payments in the past, backed up by consistent profits.
Searching for reliable dividends
Unfortunately a reliable dividend is a relative term rather than 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 which 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 which a) doesn’t care about shareholders or b) doesn’t know how to effectively manage the company’s cash flows.
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 10 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; they do not have a good reputation with many investors. Earnings are easily manipulated, and clever accountants can tweak them to produce results that the company’s management want 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 10 years. If a company made a profit in 10 years out of 10, then that’s good. If there were 9 years of profit then that’s not quite so good, but is still better than average. If there were only 3 or 4 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 2 or 3 losing years in the last decade.
Some people might balk 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 10 years or more. So if an investment might last for 10 years, I think it’s only sensible to look back and see how the company did over the previous 10 years.