As interest rates have fallen for gilts, savings and bonds in recent years, investors have increasingly turned to shares with high dividend yields as a way to compensate for lower rates elsewhere in the market and grow their income stream and capital base in the longer-term. While there are plenty of benefits to building a dividend-focused portfolio, it’s critical to be aware of the seven "deadly" pitfalls and mistakes associated with the strategy.
Reaching for Yield
Ultra-high dividend yields (8%+) can be particularly attractive in this low-return environment, but it’s important to resist the temptation to load up on these shares. Most ultra-high yields are simply too good to be true and are more often a product of a poor outlook for the company than a generous dividend policy. Indeed, a recent study by Société Générale found that "an abnormally high yield is generally a sign of distress" and showed that groups of shares in the ultra-high yield categories are more likely to have lower realised yields. This makes sense—given that shares have historically returned about 8% to 9% over the long-term, a share paying a sustainable 8% yield should be very attractive to investors. But if all investors agreed that the share’s 8% yield was sustainable, they would pile into that share and as a result drive the yield down. Every so often, the market gets it wrong and there can be bona fide opportunities in the ultra-high yield space, but more times than not the market gets it right, and investors who reach for those yields get burned.
Disregarding Valuation
One school of thought in constructing a dividend portfolio is to buy shares for their yields alone, to focus only on the income and pay little attention to valuation. While focusing on income may save you from making emotional trading decisions based on share price volatility, constantly overpaying for shares is not a formula for success, either. Always insist on buying shares with a "margin of safety”—that is, at a meaningful discount (at least 10-15%) to your fair value estimate.
Not Diversifying
High yield shares tend to be clustered in a few sectors that often have weaker long-term growth prospects—i.e. utilities, telecoms and insurers. While a few shares in these sectors can be fine additions to your portfolio, buying too many of them in an effort to maximise your average dividend yield can be dangerous. As we saw with banks during the financial crisis, bad news in a sector can lead to a string of dividend cuts across the group and thus quickly undercut your strategy. A well-diversified portfolio can typically absorb the impact from a dividend cut here and there, but if a number of shares cut their payouts in a short period of time it could permanently impair your portfolio’s ability to generate income in the longer-term and reduce your capital base. While adding lower-yielding shares from other sectors may lower your initial yield, it could serve to increase the sustainability of your income stream.
Setting It and Forgetting It
A well-constructed dividend portfolio lends itself to a patient, hands-off strategy, but turning a blind eye to events that can affect a company’s dividend policy can be a mistake. Most of the time it’s best not to tinker, but there are certain cases where it's wise to reevaluate your long-term thesis on a share. For example, if a company borrows too much money to make a large and misguided acquisition or if competition has been eating away at margins, it may be time to reconsider that particular share. Kodak, the well-known camera film company, was once the ideal blue chip dividend payer but it failed to keep up with the shift to digital photography and competitors took advantage of the opportunity. Over the next decade, Kodak cut its dividend twice, sales declined and the company ultimately filed for bankruptcy earlier this year. Hindsight is a luxury, but Kodak's eroding economic moat could have been a good reason to sell and reallocate your capital to a better dividend share.
Ignoring the Balance Sheet
Paying too much attention to equity metrics like earnings cover and not enough to balance sheet metrics like gearing, interest coverage and net debt/EBITDA is a common mistake that dividend investors make. Creditors have a senior claim on a company’s assets and there’s a greater chance that the dividend will be cut if they are afraid they won’t be paid interest and principal. A good rule of thumb is to be extra sceptical of companies with interest coverage ratios (EBIT/interest expense) below three times or net debt/EBITDA ratios above two times.
Thinking Dividends Equal Interest
With interest rates this low, many investors aren’t receiving sufficient income from bonds and have thus turned to dividend paying shares to provide an extra income boost. However, thinking that dividends are equal to interest is a major mistake. Unlike interest from bonds, a company does not have an obligation to pay dividends—and unlike bonds, companies aren't obligated to return your invested capital by a certain date. There are many attractive qualities to dividend-paying shares, but they're still subject to the same risks as other types of shares.
Ignoring Signs of a Dividend in Danger
Not paying attention to the signs of a dividend in danger, such as declining cover and a slowing dividend growth rate, can lead to sub-par returns. Every quarter, review your companies’ financials to make sure there aren’t any emerging warning signs that could impair your portfolio's ability to generate a sustainable and growing income stream.
The Bottom Line
While there's much to like about dividend-paying shares, being aware of these seven common pitfalls will hopefully help you avoid making the major mistakes that can permanently impair your long-term results.
