2017 has been the year of growth stocks. November was the perfect epitome of this as the month saw the trend of growth outperforming value in the markets. This has caused many investors to rotate their portfolios and ditch solid cash generators in favour of higher growth companies. Too many investors or should we call them speculators have been pushing growth company valuations to obscene valuations and have left high quality free cash flow producing businesses in the dust. Its almost as if ‘investors’ have forgotten that valuation matters and instead have thrown caution to wind in search of instant wins. This has caused solid dividend payers to go out of fashion causing their share prices to drop and dividend yields to increase – something that causes my eyes to light up. As such, these are the stocks I bought in November as part of my monthly stock purchase programme:
- GSK – Bought 44 shares at £13.25 a share. Dividend Income = £35.2
- Imperial brands – Bought 5 shares at £31.70 a share. Dividend Income = £8.55
- National Grid – Bought 17 shares at £8.95 a share. Dividend Income = £7.14
- BT – Bought 80 shares at £2.49 a share. Dividend Income = £11.56
- INTU – Bought 72 shares at £2.05 a share. (Not going to count the annual dividend income with this stock yet as merger offer has come last week and in the process I have received a quick 20% gain.)
- RB – Bought 4 shares at 65 a share. Dividend Income = £6.46
As you can see from the above, all the stocks bought during November were high yielders with an average yield of 6% – the exception being RB. Just a quick note on RB before I discuss high dividend paying stocks. RB is one of the highest quality names found on the London market. It has a stable of high performing consumer brands that have characteristics I like; exposure to categories where private label is less entrenched (consumer health) and its products are well entrenched in emerging markets. At present I think RBs share price is currently on the high side of fair estimate and that is why I have only initiated a small position. If the share price had to fall, this is a name I would look at with deep interest.
The Advantage Of High Dividend Paying Companies
In time gone by, dividends used to be some boring little sideshow that only retirees paid any attention to. Most stock investors would purchase companies for capital gains, not dividends. The objective used to be to buy a stock low, sell it high, and pocket the difference as a capital gain.
But the buy low and sell high mantra did not always work. There were years on end where stocks would trade sideways leaving investors with nothing to show for parting with their money. Investors could be holding on to a stock for years and earning capital losses rather than gains. In such stagnant environments, dividends grew increasingly more valuable, as investors could at least collect something for the time their investments were tied up. The lust for dividends grew ever since and now dividends make up a good chunk of an investors total return.
Buying into high dividend stocks can be a great investment. There are many reasons for that. One of the main reasons is compounding interest (LINK), which any investor knows can be a big money maker. You will get a higher yield if you have high dividend stocks as part of your investment portfolio. This yield is then reinvested. This process of reinvesting repeats itself for as long as you own the stocks. As the interest on your investment is compounded, it will greatly increase your return on these investments.
Another reason for following this strategy is based on the fact that high-dividend stocks tend to outperform the broader market over time. According to the asset manager Dreyfus, U.S.-based dividend-paying stocks returned an average 9.3% annually from January 31, 1972 through December 31, 2013, far exceeding the 2.3% average annual return for stocks with no dividends. Additionally, more than half of the total return of U.S. equities from 1930 through the end of 2010 was the result of dividends rather than price appreciation.
Historically, dividend-paying stocks also perform better than the overall market during times in which stock prices are weak. Since stocks that pay dividends are generally more conservative and have stronger cash flows than those that do not, investors tend to gravitate toward dividend payers during times of trouble.
Dividends, by returning actual cash to shareholders, also provide an indication of the strength of the business underlying the stock. Additionally, companies tend to use their resources more efficiently when they are less plentiful – which cash is once dividends have been paid. Higher dividends mean more cash in the hands of investors, and less in the hands of a management team that may not necessarily make the right decisions.
But before investing in a high dividend stock you need undertake due diligence to ensure the dividend is sustainable and is able to grow over time. You need to ensure the dividend is well covered by free cash flow. It is also advisable to go through the dividend history as well as the stock price history over the last twenty- thirty years. Invest only in stocks with a history of increasing dividends to ensure that only high quality paying dividend stocks find a place in you investment portfolio. High quality dividend stocks offer the benefit of increasing their dividend and the market value and are usually much less volatile and far more stable than the wider market.
As an investor, you also need to be wary of stocks that are spotting dividend yields that are extremely high. This should be an indication that all is not well with the company. Sticking to older mature companies in this way will help you avoid committing a common mistake that traps and erodes many an investor’s cash. The mistake is made when an investor conducts a search for dividend stocks on a stock screen, sorts the results according to highest yield, and then picks the top three or four dividend payers, often with great expectations.
If you have ever conducted such a search, you would have found many stocks with outstanding yields greater than 10%, 15%, even 20% and more. But if you pull up a chart of the company’s latest performance, you will find it has recently taken a hit to its stock price. Yield is calculated as a percentage of the last dividend payment over the current price of the stock. If the last dividend payment was made weeks or months ago, and if the stock has plummeted since then, the yield percentage will be unusually – and unsustainably – high.
Sure, the yield currently works out to 15% or more, but what was the yield at the time the dividend was paid? If you see such a plunge in stock price, you can be pretty certain the next dividend will be slashed to about the same percentage it was before the plunge. In fact, in many cases, the dividend may be suspended altogether until the company sorts itself out.
As a final point, it is important to remember that by investing in a dividend stock is often a tradeoff between yield and growth
Finally, always consider the trade-off when investing in dividend stocks. In exchange for steady income, you are generally giving up stock growth, which in a hot stock market can often surpass the percentage yield you are getting from your dividends. But that why dividend reinvestment exists – its a safer way of adding growth to your portfolio.
A Note On GSK – A Potential Dividend Cut
Shares in GlaxoSmithKline’s have fallen by over 17% in the year to November leaving it on an undemanding 11.9 times earnings and spotting a 6%+ dividend yield. One of the big reasons for this is due to the potential of there being a dividend cut following speculation the drugs giant might buy US-listed Pfizer’s consumer division or Germany’s Merck’s consumer division. 2018 could be an expensive year for the firm if it goes ahead in purchasing assets from the above two mentioned companies as well as buying Novartis’s minority stake in Glaxo’s consumer joint venture. Looking at buying out Novartis and buying the consumer division of Pfizer ( which looks like most likely), GSK is expected to spend close to $24 billion next year. This high capital could result in a dividend cut as the ratio between net debt and earnings would be a demanding 3.5 times if these transactions were funded entirely by debt.
It may seem strange that I bought shares in GSK in light of a potential dividend cut but I do have my reasons. Firstly, the current GSK share price indicates that there is a high probability of a dividend cut taking place and thus this is essentially priced in. Secondly, when a company cuts a dividend, the share price does not always fall. Share prices fall when dividend are cut due to a company being in trouble. On the other hand, when a dividend is cut for business growth reason, share prices do increase. With GSK, the reason for a dividend cut would be for acquisitions to grow the business and thus the share price might rally. There might be panic selling in the days following the dividend cut as retirees who require income today will sell out. But this in my opinion would create an opportune moment to buy shares. Thus, I have not built up a full position in GSK yet and will wait for this story to play out.