Monday, 30 March 2015

3 things to consider before investing for dividends

There have always been investors  for whom dividends is the most important element of a share investment.  Growth in share price has not been their primary concern.  Some bloggers (such as Dividend Mantra) have their whole investment strategy built around dividends and replacing their income and achieving financial independence through them.

In the current low interest rate environment this approach has become much more common.  Investors have not been able to get the yield they desire from term deposits and online savings accounts so they have turned to high yielding shares (such as banks and infrastructure shares) in order to get the yield they desire.  Why would you invest in a bank account at 2.5% p.a. when you can easily invest in a bank and get a 5.0% yield on a commercial bank or infrastructure stock?

A problem occurs when some investors look at these stocks and their dividend yields like they would a term deposit which is completely the wrong way to go about it.  This post will try and highlight some of the things you should be looking out for when you invest in stocks for their dividend yield.

Things you should consider when investing for dividends is your focus

There are risks when investing for dividends is your primary focus especially in an environment like this.  Below are just a few of the questions you should be asking yourself whenever you undertake an investment like this

1. If interest rates revert to more 'normal' levels what will happen to the value of this stock?

A lot of high dividend stocks have been driven up in price as people search for yield outside the fixed interest sectors.  If interest rates return to more 'normal' levels and people no longer have to invest in these stocks to get the yield then the value of your investment in these stocks may fall.

This is a function of the current market that you can't avoid and is a risk you need to know that you're taking on by investing in high yielding stocks.

2. What is the outlook for the company that you are investing in?

Dividends can be cut.  It actually happens far more often than you actually imagine.  A high yielding stock is often high yielding because people see problems in the companies future and the stock price reflects this.  I once invested in a stock that had a very healthy dividend only to see that dividend suspended for 3 years after I invested in it.

3. Are you ignoring a stocks that may pay high dividends in the near future?

Sometimes the current dividend yield may be very low however this is because there is an earnings bump coming for the company that will see them lift their dividend in the near future.  I once invested in a stock that paid a very small dividend (I didn't invest in it for the dividend) however as the company recovered and got back on it's feet it started to generate significant cash which it then passed out to shareholders in the form of dividends. 

Don't focus exclusively on the current dividend yield.  Try and look at what the growth of the company's earnings will be as well.

If all this seems like too much effort...perhaps investing in stocks for their dividends is not the right strategy for you

If doing all the work involved in the above 3 questions seems like too much effort for you perhaps investing for dividends is not what you should be doing.  You can't take a set and forget approach to stocks in the same way that you an to fixed income / term deposit type investments.  Even though your reason for investing in a stock is different (dividends versus capital growth) the same amount of effort should be going in to it

Investing for dividends is really 'in vogue' at the moment and if you are planning on jumping on the bandwagon you should know both the upsides and the downsides.

Disclaimer: I do not provide financial advice.  Obviously your own situation is very different to mine or anyone else's so please consult your financial advisor before you decide to do anything.

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