While dividend strategies can seem like straightforward ways for investors to maximise their income, here are five potential pitfalls.
Equity investors come in all shapes and sizes. While some invest in equities in the hope that they are buying the next Apple or Amazon, others, typically those who seek some form of income, invest in high-yielding companies as they believe that “a bird in the hand is worth two in the bush”.
As a result, such investors will usually have a portfolio of high dividend-paying equities. Their chief concern is that the income is paid out, and they are often relaxed about their invested capital value.
Such a strategy has benefits for investors. Not only does investing in such companies produce a relatively stable source of income, but dividend payouts rise in line with inflation. With the returns from cash and savings accounts continuing to lag behind the inflation rate, this is helpful for investors as prices rise.
History shows that by investing in a selection of high-yielding equities, the overall performance is often ahead of its respective benchmark.
While investing in dividend strategies can seem like a straightforward way for investors to achieve a source of income, the prominent collapse of high-yielding firms such as Carillion have put the approach in the spotlight.
So what are the risks of investing for dividends?
1. Tax implications
Not all companies with the same growth profile pay the same amount in dividends. This is partly down to different borrowing costs and the opportunity for re-investing the capital, but it is also a function of how the dividends are treated.
Some economies, such as the US economy, have relatively low dividend yields, as many directors argue that the income tax rate applicable to dividends is greater than capital gains tax.
2. Dividends can be erratic
Dividends can be unpredictable and are ultimately paid at the discretion of directors. Investors need to take this into account when deciding which firms to invest in.
3. Correlation of dividends
In some sectors, similar companies often have the same growth profile, and therefore may have the same dividend yield.
Something that caught out many investors during the financial crisis was the banking sector. Prior to the crash, the dividend yield for European banks was around 6%.
Many investors thought that they had a diversified portfolio, as their dividend income was being produced by different banks in different jurisdictions. In reality, when a crisis hits it often affects everything in a sector.
The result was that the yield from dividends in the banking sector went from 6% to 18%, then to a negative yield, as banks were forced to raise emergency capital rather than distribute excess capital.
4. Mature companies
Companies that pay high dividend yields tend to be firms with relatively low growth prospects. If a firm had high growth prospects, why would they be distributing their capital? As a result, the capital growth expectations of a high-yielding company may typically be lower than that of a younger, growing company.
5. Erosion of capital
Cutting a dividend is usually the worst-case scenario. The danger is that when a company cuts the dividend a large number of investors will be forced to sell their shares as they cannot invest in a non-income producing asset.
The shareholder will experience a double whammy of a loss in their expected yield as well as the loss of their capital.
In attempting to create an optimal portfolio, investors need to consider the total return, which combines both capital growth and income distribution.
In too many cases, investors have been drawn to investing in high-yielding equities, in part as they struggle to get a return on their cash deposits, which turn out to be value traps.
The difference between a 4% dividend yield and a 5% dividend yield is a fall of 20% in capital terms, so while dividend-paying stocks have a place in portfolios, they should be those that are considered to be world-class competitive companies.
Robert Clough is an investment manager at Thesis Asset Management.