I’ve been investing in dividend shares for a long time. And along the way, I’ve picked up a number of thoughts from other people that help to guide my own decisions. I want to share some of them with you today.
Beware the dividend trap
The idea of a ‘dividend trap’ generally refers to irresistible fat yields. But it’s essential to understand why a dividend yield might be so big.
Yields rise not only when dividends grow, but also when share prices fall. It might just be that a company is encountering problems that could affect future yields. And forecasters haven’t caught up yet. This makes me wary of forecasts for dividend shares generally.
A big headline yield doesn’t necessarily mean it’s what I’m going to get. Or, at least, maybe not for long.
Look for cash support
I want to see enough cash to cover the dividends. Dividend cover, which compares earnings per share with the dividend, is part of it. And I want to see enough earnings to cover the payout with room to spare.
But that hides another potential trap, because earnings are not the same as cash. With the way accounting works, profits can be recorded well in advance of the cash itself turning up. And sometimes it never actually does.
That’s why, for me, digging into a company’s cash flow is essential.
Watch out for debt
Sometimes a company will prioritise paying dividends, while racking up massive debts.
My most striking examples of this are the FTSE 100‘s two big telecoms companies, BT Group and Vodafone. Both are offering attractive dividend yields. But both are under the weight of billions of pounds of debt.
The dividends might go on for years with no problems. Alternatively, share prices can slide and the dividends might be cut back. Both of those have happened to these two companies in recent years.
Check past performance
There’s an old investing reminder that past performance isn’t an indicator of future performance. It’s a warning to heed, for sure. But there’s another side when it comes to dividend shares.
I like dividend companies that have a long track record of growing their annual payments. They need to maintain the cash to pay them too. On that score, there’s a handful of investment trusts that have raised their dividends for more than 50 years in a row now.
I own shares in City of London Investment Trust, which is among that few.
Beware technology shares
Some technology companies need to plough back vast sums of cash every year into R&D. And it’s especially onerous when technologies become quickly outdated. I’m thinking of the big telecoms companies again, which are constantly spending billions on each new generation of communications technology. That’s all cash that can’t go directly into my pocket.
Compare with companies offering personal products, like Unilever. They can make the same things essentially the same way, decade after decade.
There are many things to look out for when researching dividend stocks. But these five ideas guide most of my investing decisions.