Now to the hard part: when dividend yield is no longer enough

For the last 10 or so years the choice for income investors (people who want to live of their investment returns) was quite straightforward: With interest rates hovering around zero and sometimes even negative, equities (stocks, shares) with a solid and improving dividend were the go-to investment. If the underlying companies were in stable, defensive industries even better. Buy Coca-Cola shares once and forget about them while receiving a dividend every few months. The drinks maker has not reduced its dividend since more than 50 years and the share price has slowly but surely gone up over the years. What can go wrong, right?

The (investment) world has changed somewhat. Inflation (prices go up, money is worth less) has returned for a variety of reasons that we don’t want to discuss here. Suffice to say that the tried and tested response to bring inflation back under control is for Central Banks (big institutions that look after how much money is in an economy and how fast it moves around) to raise interest rates (how much people need to pay to borrow money). So instead of having to pay the banks to hold your money, the banks have to pay you. That is good news for savers who keep large amounts in their accounts.

It also changes the way an income investor looks at stocks. When you can receive 3-4% interest on your savings with very low risk from your bank, a dividend worth 3% of the share price (dividend yield) does not look so exciting anymore. Besides, the company will need to spend more money paying for its debt and may spend less on dividends or new investments. Suddenly the investment decision moves from “(1) how bad can the company get?” “(2) how attractive is the dividend?” to “Is the share offering enough potential upside to justify the risk?“

While the first two questions are reasonably manageable, the last one can be more tricky. Let’s take a pharmaceutical company with reliable patents and drug franchises. Business does not change much and is not affected significantly by the economy either. Again, the company is paying between 3-4%. Until last year, the shares of such a company would have been a reasonable store of value, a good place to park your money. The share price may move around a bit but you don’t plan to sell and your dividend is safe. With interest rates at similar levels, it seems unnecessary to tolerate the volatility (how much a share price moves around) just to get the dividend, when you can get the income safely from the bank. Suddenly, these traditional income stocks do not look so exciting anymore and will need to be analysed with the same lens as other shares.

While dividends will remain an important part of the return on a stock, we now need to go deeper into the business and its prospects. Is the revenue of the company likely to grow and will it be able to improve returns? Are these prospects already reflected in the valuation (how much you pay for a share)? And the tricky one: is the company paying a high dividend because it does not have any good ideas for the business?

We can still side-step this challenge for now by buying “safe” shares that have dividend yields between 5-6%. We should not look for stocks paying more than 6%. To understand that, let’s be a bit more precise about what we mean by paying here. There are different ways to talk a dividend yield. It is always an expected number of a payout that is yet to come. Sometimes people forecast a dividend yield, i.e. what they think will be paid out. Then there is the practice of taking the dividend from last year divided by the current share price. If the expected dividend yield is too high, at least one of two things has happened: Either the dividend estimate comes from a time when the company could afford to pay much more than now or the share price has come down significantly. Or both. I found that dividend yields over 6% are more often than not bad signs. When in doubt, stay clear.

Where does all of this leave us?

• When in doubt about a company, interest is now a better option than dividends.

• Strong dividend-paying stocks can still be good investments if the underlying business is strong and the valuation attractive.

• Stock-picking becomes a lot more important. If you

Happy investing!