Dividend investing – Creating “certainty” in an uncertain environment

Date: September 27, 2013

The stock market has a habit of changing direction just when you least expect it to. As a bull run gains steam, the overwhelming optimism that the market can only head higher, and is driven by the “greed” sentient, becomes so irresistible that even the most conservative investors are eventually drawn into the fray. The market is usually at its most vulnerable when virtually everyone is a bull. At that point, all it needs is a trigger to spark off a selling panic that could within a short space of time, cause investor sentiment to plunge into a state of dire despair.

At the same time, in a bear market, the investor sentiment is one of “fear”. Even well run and good companies are trading at below their fair value. It is usually at this time that investors can easily pick up good investment opportunities but yet fail to do so.

More recently, we have seen investors express a different view of assets of emerging markets, evident since last year. But in with the back drop of uncertainty caused by the expected tapering of quantitative easing in the US has the market in a dive in the last few months, particularly among emerging market currencies.

The MSCI index for emerging market stocks has fallen more than 5 percent this week and a year-to-date loss of around 15 percent all this on the back of U.S. Federal Reserve planned wind down of its 85 billion-a-month asset-buying programme and Chinese data confirming a sharp decline in the world’s second biggest economy.

The currencies of these economies have taken a beating too. A basket of emerging market currencies has declined over 9 percent between May and early September 2013, with the Indian rupee and the Indonesian rupiah taking the biggest hit. This raises a big question – is Asia headed for another reprise of the 1997 crisis?

Many economists and leaders are of the opinion that, while Asia is grappling with the similar dynamics as the pre-1997 crisis, the situation today is different and Asia would not be headed for a repeat of 1997.

According to Lim Say Boon, Chief Investment Officer, DBS Group Wealth Management and Private Bank, in his article in BT’s Wealth magazine, the emerging markets current account balances are stronger today as compared to 1997 and the external debt to GDP is lower.

In my previous article, I shared a list of 8 simple investing rules to help SIAS members to safeguard their investments. It may be worthwhile to pay serious attention to Rule 8 during a bear market. This rule suggests having a defensive plan to ensure you are able to hold on to your best stocks. While there are many investment styles and strategies that one can discuss for creating a defense strategy, today I want to share about dividend investing, which is a style commonly used by investors seeking a steady annual income. Basically, dividend investing involves buying the shares of companies that pay a decent annual dividend. Investors normally filter the market for dividend stocks by computing dividend yield, which is the historical annual dividend per share (DPS) divided by the current share price. This dividend yield adds to your total investment return over the long term. It gets even more attractive if the company is able to steadily raise its DPS. Not only does a rising DPS translate into higher yield on your purchase price, it is also a signal to investors that the company is confident of its business outlook and generally leads to an increase in the stock price.

In Singapore, investors are now more discerning and are realising the rewards of investing in companies that pay attractive dividends. This is clearly evident from the increasing popularity of Real Estate Investment Trusts, or REITs, which is a market segment that has continued to grow rapidly. As a result, more companies are broadening the appeal of their shares by marketing themselves as dividend stocks. Indeed, a growing number have also taken the extra step to institute a formal dividend policy, guaranteeing shareholders a minimum percentage of net profits as dividends each year. However, a formal dividend policy is not an assurance that the company’s DPS will be maintained. So if the company’s profits fall, the payout to shareholders will decline in tandem. A fixed payout from profits also means that an increase in the company’s share base will result in a dilution of its DPS. Given these drawbacks, it is wise not to exclude companies just because they do not have a formal dividend policy. This is because many companies that have a strong track record of paying generous dividends, prefer not to be tied down to a dividend policy to ensure they have some degree of flexibility if an attractive acquisition or investment opportunity arises.

The methodology for selecting dividend stocks is fairly straightforward. First and foremost, investment decisions should not be made based solely on the stocks offering the highest dividend yields. In some cases, the high dividend yield may be a result of a share price weakness and a sign of serious problems at the company. A company in this situation is likely to have difficulty maintaining its dividend, which means a drop in the expected yield at its current share price. A good starting point would be to set a desired yield, say 5 percent, and than draw up a list of potential dividend stocks. I would recommend a systematic approach based on a company’s dividend track record where those with a history of growing dividends are ranked above those that have flat dividend payments.

The next step is to assess the company’s business model to determine if it has the ability to raise or at least, maintain future dividends. As dividends are paid out of cash, the focus here should be on operating cash flow rather than net profit, which is an accounting measure. Companies that generate a steady or growing operating cash flow are in a better position to fund their dividends compared to those that are unable to consistently generate cash. One useful tool is the dividend coverage ratio, which is calculated by taking the operating cashflow per share divided by the last paid dividend. A ratio of 1.0 or more indicates a high degree of confidence that the dividend can be paid while a ratio below 1.0 suggests that the company’s operations will not generate enough cash for it to maintain the dividend. Besides cashflow, it is important to check the strength of the company’s balance sheet. Good dividend stocks should have no bank debt or a low debt-to-equity ratio. A strong financial position enables the company to borrow without taking on too much risk in the event it needs to support its operations or fund its dividend during a cyclical downturn.

These are some of the key factors to consider when seeking dividend stocks. Dividend investing is not only for the income-oriented investor but a useful strategy for those aiming to reduce investment risk and find a level of “certainty” in our ever changing and uncertain environment.

Happy investing.

Richard Christopher Dyason

Richard is the General Manager at SIAS and previously Vice President at SGX. He has over 13 years of experience in various management positions in the financial services and over 25 years of management and consulting experience. He has been a trainer for several organisations and He is passionate about investment training and educating investors and had spoken at many SIAS, industry and public events.