If you like dividends, here's a better way to invest

Avoid dividend disappointments by focusing on whether or not a stock is undervalued. The cash will follow. 

In November 2015, a member asked us a simple question – Dick Smith Electronics’ stock had halved in price and was now trading with a dividend yield of 17%. Was this a buying opportunity?

We get hundreds of questions like that. In this case, we said we were sticking by our Avoid recommendation and that investors should ignore the yield, as it was probably misleading. Two months later, Dick Smith was bankrupt. Not only did shareholders never see another dividend, they lost all their capital as well.

If there’s one ratio that leads investors astray more than any other, it’s a stock’s dividend yield. It’s simple to calculate – the most recent annual dividend divided by the current share price – and it has some major advantages over other measures of value. 

For one thing, dividends are real cash delivered to your bank account, not a mystical earnings figure reported by the company and prone to accounting manipulations. There’s also evidence that buying a basket of stocks with above-average dividend yields tends to outperform the overall market.  

Our own experience weaves a similar tale – since inception in 2001, our Equity Income Portfolio has returned 12.5% a year, whereas our Equity Growth Portfolio has returned 9.4% (both, we should add, outperformed the overall market return of 8%).

Nonetheless, focusing solely on the dividend yield is a really good way to land yourself in trouble. For one thing, the dividend yield is a historical measure. When you buy a stock, though, the only thing that matters is what will happen in future. 

Another issue with dividend yields is that they tell you nothing about the underlying risk of investing in a stock (just ask those Dick Smith investors).

Business risk can surface in many ways, with a big one being the company’s financial strength and balance sheet – even a great company may be riskier than a mediocre one if it’s loaded with debt. A company’s competitive position and ability to generate cash are also important. Business risks of one form or another are the main reason we’ve stayed away from seemingly attractive yield stocks like the big banks, AMP and Harvey Norman.  

Growth matters

What’s more, the dividend yield is unrelated to a company’s ability to grow. If anything, a high payout ratio could indicate a company has fewer opportunities to reinvest profits into growth projects. Sometimes a falling payout ratio is a good sign if it reflects management allocating more capital to operations or acquisitions.  

If you’re a retiree, however, you may be thinking: ‘The cruise line won’t accept paper gains when I go to buy a ticket; they want cash. And that takes a dividend.’  

It may seem counterintuitive, but buying a high-quality growing company with a modest dividend yield could still be your best option. 

We recommended members buy Hansen Technologies in October 2015 when it had an unassuming dividend yield of 4%. What we liked about the company, however, was that it was retaining earnings each year and using those funds to buy undervalued competitors and to grow the business. It was money well spent: earnings have risen 60% since we bought the stock. 

Going back to 2015, let’s say that to fund your retirement you needed a 7% yield. You had two options: find a stock that pays 7% – and probably carries significant business risk if it trades at that price – or you could accept Hansen’s 4% yield and then sell 3% of your holding each year. Either way, you’re getting your 7% cash in the bank. 

If you had followed the latter method, your Hansen shareholding would have shrunk by around 7.5% since then but the growth in intrinsic value per share (thanks to the 60% earnings growth) has more than offset the declining number of shares you own. In fact, Hansen’s share price has almost tripled over that time. Not only did you get your 7% yield, you got bumper capital growth too.

When considering which stocks to add to our Equity Income Portfolio – which will soon launch as a listed fund – the current dividend yield is only one factor in our decision. Our priorities are: (1) keep your capital safe; (2) invest it in high-quality, undervalued companies; and (3) target companies that offer a suitable yield and decent growth prospects.

As Hansen and Dick Smith demonstrate, finding hidden gems and avoiding dividend traps is a much better strategy than blindly investing in high-yield stocks. 

Our Intelligent Investor Equity Income Portfolio is now available as a listed fund. Holdings in the Fund will mirror our current Equity Income Portfolio, has the same low costs, but you can buy it on the ASX. You can save yourself the broking commission by applying during the initial offer.

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