Interactive Investor

10 things you must know about dividends and income investing

23rd November 2022 12:37

Faith Glasgow from interactive investor

Faith Glasgow examines how to use dividend investing to build your wealth.

Dividends are regular payments out of profits or reserves made by companies to shareholders, to incentivise or reward them for investing. Over the years they contribute a significant chunk of total returns from the stock market, especially if they are reinvested rather than withdrawn as income.

For example, Hartford Funds calculates that since 1960, 84% of the total return from the US S&P 500 index can be attributed to reinvested dividends and the power of compounding (see below).

So, what do investors need to think about when they are contemplating putting their money into dividend-paying investments?

1) The messages behind the yield  

Dividends are often presented as a yield - a proportion of the share price in percentage terms, so investors can see how much they are receiving relative to what they paid. This can then be compared to the average yield for that industry or for the broader index.

A high-yielding company is paying a generous dividend relative to its share price. This could be because the company is generating a lot of free cash and pays it out to shareholders (mining companies, for example), or because it has a strong commitment to generous dividends (oil companies such as BP (LSE:BP.) and Shell (LSE:SHEL)).

However, a very high yield of 7-8% or more, could also be because the company is facing difficulties and its share price has dropped. A fall in share price could indicate a dividend cut is on the way too. So you do need to look at dividend yield alongside other measures such as dividend cover (see below) and payout history if you’re buying for income.

2) Dividend payers can help protect your portfolio  

If you’re still employed and earning an income, and haven’t yet started the process of retirement, you probably don’t need to draw a dividend income from your investments. Nonetheless, it’s still worth holding income-paying holdings in your portfolio.

For a start, some sectors such as tobacco, utilities, healthcare and pharma stocks, not only pay generous dividends but are in defensive sectors that tend to weather economic downturns relatively well.

3) Compounding turbocharges total returns

There is another powerful reason to hold income stocks. By reinvesting dividends rather than taking income you can boost your total returns dramatically. That's because the reinvested cash buys additional shares or units that themselves generate more dividends to be ploughed back in, and so on - a process known as compounding.

Dividend reinvestment calculators are available online. To give a hypothetical example, let’s say you bought 1,000 shares at £10 each and they paid a 50p dividend which grew at 2% a year. Assuming no capital growth but with dividends reinvested, after 20 years you would own 3,326 shares and your £10,000 investment would have grown to £33,260 - an annualised return of 6.2%.

If you took the dividends as income instead, the total return (including capital and payouts) would be worth £22,390, amounting to a 4.1% annualised return.

If you have an ii account, then automatic reinvestment of dividends is free and easy through your online account

4) Not all companies pay dividends

However, not every company pays its shareholders. Dividend-paying companies tend to be larger, well-established businesses with steady profits and more spare cash. To put that into context, £85 billion (88%) of the total £97 billion set to be paid out by UK plc in 2022 will come from the FTSE 100 constituent companies, according to Link Group’s latest UK Dividend Monitor; they currently yield around 3.8% on average.

Small companies, in contrast, typically use their profits to reinvest and grow rather than paying out to shareholders. If they’re successful, these growth companies can be hugely rewarding over time; but as the past year has shown, they can also be volatile and they’re more likely to fail altogether. Growth investors are counting on long-term share price increases, whereas dividend investors are rewarded every year, even when the share price is struggling.

But be warned - dividends can be cut or suspended if the market crashes or the company gets into trouble. There are no guarantees.

5) Look overseas for income opportunities

The UK is a longstanding and fertile hunting ground for income seekers, but companies in other parts of the world, including Asia, Europe and some emerging markets, are also embracing a dividend-paying culture that can be easily accessed through focused investment funds and trusts.

The two global equity income sectors are good places to start for broad income-focused choices. Yields tend to be rather lower than in the UK equity income sectors, but there’s a big portfolio advantage in the wider diversity of market conditions and individual companies covered.

6) Dividend cover is important

If you’re dependent on a secure dividend income, one key measure is the dividend cover ratio, which indicates the number of times a company could pay its current dividend from its current net profit.

A ratio of less than 1 means the dividend is not covered by income and the company is having to use reserves to supplement it, which could leave it vulnerable. A ratio of 2 or more shows the company could pay its dividend twice over; it is generally considered a healthy and sustainable level of cover for the long term.

7) The value of dividend growth

While a meaty payout may be alluring to income investors this year, if it doesn’t rise in coming years it will be worth progressively less, especially at a time of high inflation.

It is therefore also well worth looking at year-on-year dividend growth. Not only is a long history of rising payouts a useful hedge against inflation, but it signals that the company is well placed to continue growing in the future, and also that it values and wants to reward its investor base. And it can help to attract new income-seeking investors, thereby supporting the share price.

Additionally, according to research on the S&P 500 from Hartford Funds, dividend-growing stocks outperform the broader set of dividend payers over the long term.

8) Dividend heroes for a reliable rising income

Investment trusts in particular have successfully promoted their long-term rising dividend strategies. Unlike open-ended funds, they are allowed to hold back up to 15% of dividends to build a reserve, which can be used to bolster payouts in leaner years.

The Association of Investment Companies (AIC) introduced the concept of “dividend heroes” – trusts with unbroken records stretching back decades – some years ago. The leading heroes have maintained or grown payouts for up to 56 years, with a second tranche of ‘next generation’ heroes on 20 years-plus.

Importantly, although many of these trusts are equity income-focused with generous yields, not all are. So while City of London (LSE:CTY) pays a 4.8% yield and abrdn UK Income Equity a generous 6.5%, Bankers (LSE:BNKR) yields just 2% and F&C Investment Trust (LSE:FCIT) 1.5%.

9) Keep an eye on ex-dividend dates

When you’re thinking about buying an income share, do look at its ex-dividend date. This is important because it is the date on which you must own the share in order to receive the dividend payout. If you want to buy a stock and be sure of receiving the payout, purchase it before the ex-dividend date; if you buy on or after that date, the seller will receive the payout.

Because investors are keen to get the dividend, share prices tend to rise before the ex-dividend date and fall on that date because the opportunity has passed.

10) Payout frequencies can differ

A final thing to look out for if you’re going to be depending on dividend income flows is the frequency of dividend payouts.

Some are annual, but these days most are paid quarterly or half-yearly. Around 60 funds and trusts pay a monthly income, which can be welcome when it comes to household budgeting and cash flow.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.