The payout that you plough back
Dividend yield can reveal several things about a company’s history, but the nature of the beast means it should not be a highly weighted factor when making your stock selection
WHEN companies whose shares you hold pay dividends and you reinvest the payouts, it is like getting compound interest in your portfolio. The inflation-beating benefits are easy to appreciate — but just how much should you load your portfolio with companies that are known to stick to a healthy dividend-paying policy?
Picking shares that regularly pay dividends may mean going with mature companies, but there are risks involved with packing too many of these shares in your portfolio.
“Dividend yield should be a part of the stock selection process rather than the determinant of one’s stock selection,” said Bhekinkosi Khuzwayo, a quantitative analyst at Stanlib.
“Actually, if you were to just select the 10 stocks with the highest dividend yield, this would leave you with a massive weight in real estate, because five of the top 10 are property shares. It’s important to understand the inherent risks involved
The price you pay for that dividend yield is not always worth it
with such a strategy.”
Khuzwayo said that on a historical basis, dividends told you something about the company — in particular, how it had been generating cash. “But trying to extrapolate from dividend trends is not a clear view on the economy or the company. It can be done, such as in a quant fund, but it’s important to know the risks. You should always understand the company. All a good dividend yield means is a good dividend yield. There’s no guaranteed growth associated with it.”
He mentioned the tribulations of African Bank as an example. “Companies can and do run into trouble, even if they’ve recently had a history of paying out handsome dividends and continue to do so. Be careful when you screen companies for dividends — rather look at opportunities. A healthy company will end up paying dividends anyway — it’s a natural part of a healthy portfolio that you’ll reap both dividends and capital growth. High dividends don’t always mean the same thing from company to company, and past performance is not necessarily a good indicator of what is to come. The price you pay for that dividend yield is not always worth it.”
According to Khuzwayo, although dividend streams have been highly sought after since the 2008 crisis, an end to quantitative easing could signal big swings in the rerating of company valuations, in which case good dividend percentages will be virtually irrelevant.
“What really determines your total return is the dividend yield plus the price-to-earnings rating plus earnings growth. That PE ratio may experience a rerating at any time, due to market forces, and the 2% to 3% dividend you might get won’t compensate for a big drop in the overall return. These various factors in the equation will contribute differently in different phases of the business cycle.”
It is also important to be aware of where in the business cycle you are buying the share.
“A dividend strategy can change significantly depending on the business environment, and that can cut the shareholder’s income. After the 2008 crisis, companies started hoarding cash, which was a bad sign because during a time of low growth there was no money spent. Companies should be paying that cash back to shareholders or doing something else with it. A share isn’t worth the lower PE for the shareholder in that scenario. Also, cash on the balance sheet may be an illusion — is the company generating cash as a proper business from operations or from interest earned on that cash?”
When it comes to who pays the best dividends, resources are highly cyclical and dividends are generally not sustainable.
“Financial and industrial shares would probably make up 75% of your portfolio if you wanted dividends, because resources yield them only periodically. However, if you opt out of resources companies for that reason and there’s a big rerating of those companies for the better during an upswing, you’ll miss out on that run, only outperforming when financials and industrials run.”
Typically, dividend payers do not often change their percentage payouts significantly. Khuzwayo said through a cycle on the JSE, 2.5% was the average dividend payout percentage. Above that is considered a good yield.
Khuzwayo’s advice is to stop rein- vesting dividends only when you plan to disinvest. “You should be there for the growth anyway. Granted, not everyone has the luxury to keep reinvesting and they may need the income, but over the long term reinvested dividends can make a huge difference in your portfolio. Dividends are simply a great add-on and part of the investment process. Irrespective of your age, market fluctuations and the share price are still your major risks, not the fluctuations in dividend payouts.
“Always look for a cheap PE with earnings potential.”