4 Keys To Dividend Investing: It’s Not Just About Yield by Melda Mergen, Columbia Threadneedle Investments
We believe a disciplined dividend strategy that focuses on rising dividends from companies with growing free cash flow will deliver reliable income.
- Investors need to generate sustainable income to maintain their current lifestyle down the road.
- A dividend strategy that focuses on rising dividends from companies with growing free cash flow can deliver reliable income, and it should be a core part of any investor’s portfolio.
- Active management can play a critical role in assessing a company’s ability to grow dividends.
In a world of low growth and low interest rates, investing for income has never been more challenging. For many investors, the goal is not only to generate a sufficient stream of income but also to grow their assets to maintain future purchasing power. We believe a disciplined dividend strategy that focuses on rising dividends from companies with growing free cash flow is a vital component to accomplishing this goal, and it should be a core part of any investor’s asset allocation.
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4 keys to dividend investing
- Dividend growth. When investing for dividends, it is prudent to consider a disciplined strategy that focuses on dividend growth rather than yield alone. A high-yield strategy does not necessarily translate into a reliable stream of income. The best opportunity for success in a dividend strategy resides with the stocks of companies that can sustain and grow their dividend over time. Importantly, returns from these stocks have come with less variability.
- Sustainable free cash flow. The companies need cash, not only to pay dividends but also to grow the business. If a corporation generates cash returns that exceed what it needs to grow the asset base (i.e., the company is left with free cash flow), then it will have the firepower for dividend growth and other shareholder-friendly actions. Dividends that are not supported by free cash flow may not be sustainable.
- Payout ratio. Investors often look to the payout ratio based on a company’s earnings, but we believe this is misleading because earnings are based on accrual accounting, which can be manipulated. To assess a company’s true potential to grow dividends and avoid dividend cuts, we prefer to focus on the percentage of annual operating free cash flow consumed by the dividend.
- Active management. Assessing a company’s ability to raise its dividend is critical. A history of paying dividends doesn’t necessarily mean a company can increase or even maintain the dividend in the future. For example, many banks had a long history of paying and even growing dividends prior to the great financial crisis. However, excess leverage forced most of them to cut or eliminate dividends. Active management supported by fundamental sector research can help identify and avoid such situations.
The bottom line
When building an income portfolio, investors must balance the need for income with the need to grow assets to maintain purchasing power over time. Fundamentally, we believe that dividend growth matters a lot more than current yield, and following a disciplined strategy based on the four tenets above should produce the best results.