Careful selection can pay dividends

2013-11-10 14:00

When selecting a dividend-paying stock, it makes perfect sense to look out for companies with pricing power, as this means they can maintain solid margins, writes Neesa Moodley-Isaacs

If you’re investing with a view to earning an income, you could do worse than to invest in companies with the aim of earning high dividends. Dividend-paying shares behave differently from other shares or bonds in an investment portfolio.

However, if you choose this approach, you need to make sure you choose the right stocks or companies to invest in, for the right reasons.

James Lamont, managing director at BlackRock and lead product specialist for the global equity team, says while much focus is given to gains in a company’s share price, the same attention is, unfortunately, not given to the dividends that a company pays.

“Increasingly, dividend-paying stocks are becoming a popular source of income, having performed well in the current turbulent financial era of slow economic growth.”

While companies that can commit to recurring dividend payments are often inherently healthier companies, high dividend yields in themselves don’t necessarily signal a buying opportunity. The highest dividend stocks typically don’t offer sustainable dividend growth over time and may also indicate that a company is vulnerable.

Here are the factors you should be looking at when you are selecting a dividend-paying stock:

1 Sustainable business model

Attractive firms are the ones that are resilient, and can consistently and sustainably pay and raise their dividends regardless of the macro backdrop.

These firms typically have exposure to growth areas of the market, including emerging markets, and have predictable revenue streams and some visibility on their future prospects.

You should also look for companies with pricing power, as this means they can maintain solid margins and successfully steer their way through inflationary pressure. Due to the stable nature of these firms, volatility should be reduced compared with traditional equities.

2 Solid balance sheets

Companies also need to have a healthy balance sheet to be able to pay dividends. It is important to note how a company is managed if you want to rely on an income from dividends.

Look for companies that generate a lot of free cash flow, operate very efficiently and have low financial leverage so that profits actually go to shareholders rather than bondholders.

Having low financial gearing, in particular, is a key factor as these companies tend to navigate market uncertainty much better than their highly leveraged counterparts.

3 Companies that can pay and raise their dividends over time

Dividends are preferable to share buy-backs as they denote a strong commitment to increasing shareholders’ returns over time and signal the company’s confidence in its future prospects.

4 Global Exposure

Look for shares that provide exposure across different regions. This provides you with a diversification benefit and allows you to benefit from regional growth opportunities.

A good way to do this is by investing in global companies whose headquarter location has little to do with where they generate revenue. Good examples include British American Tobacco and SA Breweries.

Companies that can pay and raise their dividends over time

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