Invest for equity income: boring strategy but pays dividends in the long run

The following article is intended to be informative and general in nature.  It is not to be interpreted as personalised advice and it is recommended anyone reading this article seek professional advice before making any investment.  The author does not hold shares in the securities mentioned in this article directly, but is a director and shareholder of a fund which may from time to time either hold or trade these companies.

A dividend focussed strategy may not appear to be the most glamorous way of investing but when you are in an environment where there is considerable volatility and little to no capital appreciation, deriving income off your share allocation can assist in insulating a portfolio’s return.

Investing for dividends has in the past, and will continue to be in the future, a viable strategy for investors seeking to supplement their income.  With yields on cash and traditional fixed income providing very little it is important to cast the investment net wider and look towards those companies that have strong cash flows and good annual dividends.

Yes, equities are generally more risky than bonds however one could reasonably argue that buying shares in companies like Johnson and Johnson (JNJ), Microsoft (MSFT) or Coca Cola (KO) is less risky than buying bonds in any of the PIIGS nations (PIIGS = Portugal, Italy, Ireland, Greece & Spain).  The dividend yields on these three companies used in this example are greater than what can be achieved from a US 10 year treasury security.  There are several examples of stocks in New Zealand and Australia where the dividend yield is higher than the long term fixed income or term deposit rate can easily be found.  Many brokers will publish this information and some you can access free of charge off the internet or out of the weekend newspaper.

Before everyone goes rushing off to scan the papers or internet for the highest yielding securities it is important to understand that the stocks paying the highest dividend yield may not be the best ones to invest into long term.  A high dividend yield could be as a result of a falling price.  The dividend yield calculation is the annual dividend in cents per share divided by the current price in cents per share.  A falling price could signal that the dividend is expected to be cut in the near future or worse stopped altogether. 

Factors to consider when adopting a dividend focussed strategy are:

1.  The quality of the company(s) you are looking to buy – our preference is to stick to household names that are considered blue chip companies with solid balance sheets and good management.
2.  The companies track record of paying dividends and increasing dividends over time.
3.  The company’s dividend pay-out ratio, i.e. the portion of the company earnings that are allocated to paying dividends.
4.  The dividend yield of the company compared to its industry peers
5.  The dividend coverage ratio, i.e. the ratio between a company’s earnings and the net dividend paid to investors.

To implement a dividend focussed equity strategy investors have many options available to them including:

• Purchase individual companies on their respective global stock exchanges through a broker;
• Purchase exchange traded funds again through a broker;
• Purchase units in a managed fund or investment trust via an authorised financial adviser. 

It is worth noting that in the managed fund space there are a number of funds available in the U.S. which are listed on U.S. exchanges.  Currently most of the offshore managers who provide dividend strategy funds do not have investment statements which are compliant with New Zealand legislation and therefore are not available to New Zealand resident investors.  Unfortunately from our experience there is very little by the way of globally diversified dividend focussed strategies available to New Zealand domiciled investors.

For New Zealanders, from the perspective of ease of execution, diversification and cost effectiveness, to gain an exposure to a dividend income strategy it may be preferable to use vehicles such as ETF’s or offshore domiciled managed fund or traded securities.  Most investors do not have sufficient investment capital or expertise to put together a globally diversified portfolio of high yielding securities.

 
Next time you are thinking about investing your capital into shares give some consideration to the dividend.