As humans, most of us are hard-wired to seek out bargains and offer ourselves a little self-congratulation each time we save ourselves some money. Supermarkets, for example, are aware of such consumer behaviour, and their aisles reflect that in their selective and aggressive discounting. Does the same principle really apply to income stocks?
Using the dividend yield
One popular metric for finding profitable income stocks is the dividend yield. This is the value of the annual dividend per share divided by the current share price.
Many of those companies that I associate with reliable dividend payments are hitting or approaching their share price lows for the year. These would include the likes of Persimmon, Abrdn and Rio Tinto. Considering that the share price is the denominator of the dividend yield equation, then lower prices do imply that this could be an excellent opportunity for me to buy these stocks at superior yields. For example, Persimmon, Abrdn and Rio Tinto presently offer an eye-watering dividend yield of 20%, 10.88% and 11.8% respectively.
Not the full story
The problem with this is that it is a one-sided argument. It assumes that the annual dividend per share is maintained or only adjusted slightly. Given the challenges presently faced by many companies, that is a significant assumption. The fact remains that an increasing dividend yield may be singularly due to a falling share price rather than any superior commercial performance.
Dividend yield should not be viewed in isolation
Take housebuilders, for example, which often feature prominently as popular income stock investments. The headwinds faced by such companies currently are significant and include rising material costs, shortage of labour and rising interest rates in a recessionary environment. It is hardly surprising that investors have been abandoning such stocks in droves.
So, while these stocks may appear to be discounted, further analysis suggests they may yet be discounted further. I won’t be buying any of the above three companies for my portfolio any time soon.
Pound cost averaging
I do not want to leave a bargain on the table, I am human after all. Fortunately, there is a rational compromise here. If I start to regularly drip-feed smaller investment amounts into these stocks, I am taking advantage of these lower prices while not committing all my capital to a stock that may fall further. This process of pound cost averaging can prove to be an effective way to build up profitable positions in solid companies over the longer term.
Additionally, I need to consider other fundamental metrics than simply dividend yield. Dividend cover, for example, can be a useful indicator of how affordable a company’s dividend pay-out is. This is calculated by taking the earning per share value and dividing it by the dividend payment per share. Any value of 2 or more is considered sustainable.