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A Tip For Income Investors

Income investors should never concern themselves too much with the share price of a stock after they have bought it. That is not always easy to do, though….

… it is very hard, sometimes, not to take a quick peak in the papers to get some affirmation that we have picked the right stocks. And what easier way than to look up the share price.

But it is probably the worse thing that we can do.

Point is, the daily fluctuations of share prices is more often about market sentiment than fundamentals. And share prices can easily be affected by emotions.

If traders feel especially confident, then share prices could rise. But if they (and their computer algorithms) feel challenged, for whatever reason, then the price of those shares could fall.

Serious commitment

Put another way, the movement of share prices may have nothing to do with how companies are actually doing. So, from an income investor’s perspective, the daily movements in the price of shares probably has no bearing on a company’s ability to pay dividends.

A rising share price may not indicate that a company is better able to afford its dividends. Conversely, a falling share price may not indicate that a company might be unable to meet its next pay out.

An important thing to remember, if we are income investors, is that the payment of dividends by a company represents a serious commitment by management.

An obligation

Let’s not forget that a company does not have to pay us anything, ever. If it should have surplus cash, it could quite easily buy back its shares instead of paying it as dividends.

But the moment a company embarks on the road of dividends, something quite important happens….

….. it becomes a huge obligation to continue doing so. Additionally, once a company has committed itself to a certain level of pay out, it can become very difficult to reduce it or scrap it afterwards. That can be both a blessing and curse for investors.

Unnecessary strains

It can be a blessing because income investors should be able to rely on the company to continue rewarding them. But it could also mean that some companies could put unnecessary strains on their balance sheets by continuing to pay dividends, even when they shouldn’t.

To be confident that we have bought the right shares for our portfolios, we should be comfortable with our purchases at the outset.

I often liken the building an income portfolio with boiling rice. We, firstly, need to make sure that the rice is properly washed to rid unwanted foreign bodies. We should then bring it to the boil and allow it to simmer slowly….

…. At no point afterwards should we be tempted to open the lid until the rice is cooked. It could ruin the meal.

Similarly, when we are picking shares for our dividend portfolios, we should sieve out undesirable stocks. We should only include the most promising candidates.

What’s good?

The best stocks may not necessarily be the highest-yielding shares. Instead, they should be those that are most likely to maintain or even raise their pay out over time. In other words, their profits should adequately cover the pay outs.

It is worth noting that pay-out coverage amongst Singapore’s largest companies have been on the decline over the last five years. In 2012, the median operating income of the companies that make up the Straits Times Index (SGX: ^STI) were three times higher than the dividends paid. By 2017, it had fallen to just 2.3 times.

That is not exactly dangerous, unless they should continue to decline. So, perhaps income investors should be prepared to tread carefully, when selecting dividend stocks today.

A handy way to look at income stocks could be through the implied dividend growth rates. It is the amount of money that a company retains for internal growth.

Rocket fuel

If it can generate good profits from the money retained, then it suggests that the next pay out could be appreciably higher. A high return on equity could be just the rocket fuel that supercharges your income portfolio.

Amongst the companies that have solid implied dividend growth rates are the four Jardine companies. They are Hongkong Land (SGX: H78), Jardine Matheson Holdings (SGX: J36), Jardine Strategic Holdings (SGX: J37) and Jardine Cycle & Carriage (SGX: C07). Thai Beverage (SGX: Y92) is another company with a strong implied divided growth rate, thanks to its high return on equity.

The implied growth rate amongst the 30 companies that make up the Straits Times Index are normally distributed, with a large number clustered around 5%.

There are a few companies that have the potential to grow their pay outs quickly. There are also a handful that could disappoint. Faster may not necessarily be better, though.

But if we couple a high implied dividend growth rate with strong dividend cover, then we could have the makings of some interesting high-yielding shares.

Those companies have consistently reported robust dividend cover include Jardine Matheson Holdings, Jardine Strategic Holdings, City Developments (SGX: C09) and DBS Group (SGX: D05).

By comparing the companies in the two groups, we could arrive at some good income-generating candidates. These companies may not always be the highest yielding shares in the market. And generally, they won’t be. But that is the point about income investing….

It should never be about jam today, but plenty of jam tomorrow.

A version of this article by David Kuo first appeared in the Business Times.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned. The Motley Fool Singapore has recommended hongkong Land and DBS Group.