7 golden rules of dividend investing

Avoid these mistakes if you want to build a portfolio focused on high dividend yields

Fernando Luque 29 November, 2019 | 1:33AM

Candy dispensers

Building a portfolio of dividend stocks is a great choice for investors who want regular income. But there are traps investors can easy fall into. Here are seven rules of successful dividend investing.

Don't be tricked by high dividend yields
Gains from high dividend stocks are often based on poor fundamentals. In fact, a recent study by French bank Société Générale found that “abnormally high dividend yields are generally a sign of danger” and showed that groups of companies with ultra-high returns were more likely to have lower real returns.

Don't forget the ratings
Generally, when investors build portfolios centred on dividends, they buy shares simply based on their dividend yield, paying little attention to the valuation. That's a mistake. One should always try to buy securities with a safety margin, that is, with a significant discount (at least 10 per cent to 15 per cent) with respect to the estimate of its fair value.

Diversify, diversify, diversify
Securities with a high dividend yield tend to be concentrated in a few sectors that normally have weak growth prospects in the long term (such as utilities or telcos). A well-diversified portfolio can absorb the impact of a cut in the dividend of a company. Adding lower profitability values from other sectors may reduce your initial profitability but increase the sustainability of your revenue stream.

Set it, but don't forget it
Investors who want to build a well-constructed dividend portfolio must be patient, but they must not forget about the events that may affect the dividend policy of a companies in their portfolio (for example, if a company borrows too much money for a large acquisition or if the competition is eating the margins of the company, etc).

Don't ignore the balance sheet
Paying too much attention to profit ratios and not enough to the balance sheet such as leverage, interest coverage or net debt / EBITDA is a very common mistake that investors make in dividends. Keep in mind that the creditors have a higher right over the company's assets than the shareholders and there is a greater probability that the dividend will be cut if they are concerned about not receiving the principal plus interest. A good rule is to be sceptical of companies with interest coverage ratios (EBIT / interest) less than 3 or net debt / EBITDA ratios greater than 2.

Don't think that dividends are equal to interest
Thinking that dividends are equal to interest is a big mistake. Unlike the interests of a bond, a company has no obligation to pay dividends, and unlike bonds, a company is not obliged to pay back the amount invested on a given date.

Watch out for the warning signs
Don't forget to watch for signs of a dividend in danger, such as a fall in the dividend growth rate, which can lead to below-average returns. Every quarter, check the financial status of the companies in your portfolio to ensure that no danger signs are emerging.

About Author

Fernando Luque

Fernando Luque  is Senior Financial Editor Editor of Morningstar Spain.