Dividend investing

Dec 2, 2021 | Articles, Personal Finance

Merits, and considerations

  PRESTON NARAINSAMY A DIVIDEND is a payment made by a company to its shareholders, and usually comes from a portion of earnings that a business decides to release to investors, as opposed to reinvesting back into the business. A history of reliable and consistent dividends declared by a business are often a sign of a healthy and growing one. This article highlights a few key merits when investing in dividend-paying companies, as well as some factors that investors should be cognisant of when selecting these companies.

Merits

A source of income that grows over time
Dividends provide investors with a source of income that can be useful to fund lifestyle needs.

In particular, quality businesses that pay consistent dividends tend to be established names that produce goods and services forming a vital part of their customers’ lives.

As a result, they are usually highly cash-generative businesses with strong pricing power and the ability to push through margin increases irrespective of the economic and business climate that they operate in. This often results in them being able to deliver growing dividends to shareholders.

Companies with good and growing dividend track records provide investors with an inflation-hedged level of income, which helps with maintaining living standards.

A buffer during volatile market conditions
In times of volatility and negative returns, dividends provide investors with a cushion against declining share prices.

Often—even during periods of market corrections and crashes—the dividend outlook from several of the quality dividend payers still remain intact, given the resilient of their business models and cash-flush nature. This can give investors comfort that their income needs are still being met, while taking a longer-term view on the capital to recover and grow.

Steady compounders over time
Many investors often think that a dividend strategy is usually a boring one that yields average returns.

However, several of these companies have proven to steadily create shareholder wealth over time. In particular, companies that tend to grow their dividends over time often have share prices that subsequently re-rate over time as well.

In the same way that the value of a business grows over time at the rate at which its profits grow, one would expect the value of a share to grow over time at around the rate at which its dividend grows.

This holds true particularly when taking a long-term view on performance.

Attractiveness from a tax perspective
In the SA context, dividends are taxed at a flat rate of 20%. This is beneficial for higher-net-worth individuals whose income puts them within a higher marginal income tax bracket.

Considerations

High or low dividend yields?
The higher-quality dividend payers tend to trade at lower dividend yields when compared to lower quality counters.

Higher-quality companies tend to be steadier ones that consistently grow over time, whereas higher-yielding dividend stocks tend to be shares that have a few issues that the market is concerned about (i.e. a high debt burden or concerns around the business model, as examples).

The reason why some shares trade on very high dividend yields is usually a function of the price being supressed as opposed to the dividend growing. Often, shares that trade at high yields are an indication by the market that the yield is in fact at risk and not secure, given the pressures that the company faces. This makes this type of trade more of a value one as opposed to a dividend strategy—and often has more risk attached to it.

Dividend policy and pay-out ratio
The company’s dividend policy and pay-out ratio often give an indication as to how secure the dividend is, as well as the level of earnings being retained in the business.

Shares with very high dividend yields coupled with high pay-out ratios are often shares that one must approach with caution, as the dividend could be at risk.

Key insights can also be derived from investors regarding the portion of earnings that are retained by a company, and the purpose for which these proceeds will be used. Investment into credible growth initiatives, as well as a utilisation of these earnings to pay down debt, are some examples of factors that can enhance dividends going forward.

Conclusion
The above-mentioned points just highlight a few merits of dividend investing and factors that investors should look out for when adopting a dividend strategy.

Preston Narainsamy is a portfolio manager at Nedbank Private Wealth.