There are many different styles of investing out there, ranging from aggressive strategies to conservative ones. Some investors chase after growth at all costs and go for companies which do not pay a dividend at all — these companies reinvest 100% of their earnings back to expanding their businesses. Other investors may prefer a more conservative approach which emphasises asset values and dividends, providing them with peace of mind without the need for constant monitoring.
As investors grow older, their needs also change. For investors who used to adopt an aggressive growth investing strategy as mentioned earlier, they may wish to shift it towards a more conservative and prudent strategy slowly. In order to achieve this, investors need to recognise the importance of dividends and how they should form the bedrock and foundation of a safe, consistent investment strategy. Here, let’s take a look at why dividends are so important.
Prudence is at the core of dividend companies
Companies that have a long track record of paying dividends usually have a management team which is prudent and conservative. The mindset of paying dividends yearly and ensuring the business remains a cash cow are important tenets for the management, and this ensures that dividends can be paid consistently over time. The management might also have a habit of evaluating any acquisitions or mergers carefully and would shy away from ventures which are deemed too risky, or which may disrupt the dividend-paying capability of the business. Investors who choose such companies are buying into a conservative management team which can allow them to sleep well.
On the flip side, though, such management may also be prone to disruption and stagnation due to their unwillingness to adapt and take on more risks to evolve the business. Investors need to be mindful of this tendency and monitor the company and industry closely.
More conservatively financed, stronger balance sheets
These companies also tend to be more conservatively financed, with strong balance sheets (light, or no, debt loads, and a ton of cash). During tough economic conditions, these companies are in the best position to survive and even thrive as they tap on their strong cash balance to tide through rough waters. Though dividends may be reduced temporarily, they are usually restored again once economic conditions return to normalcy.
A focus on cash flow rather than just profitability
Prudent companies tend to focus more on cash flows rather than just profitability. The former represents the lifeblood of any organisation, while the latter is an accounting construct. The generation of consistent free cash flows would ensure that the company can continue to pay dividends, and also offers strong assurance to the investor that the business is being run smoothly.
The Foolish takeaway
Investors should recognise that dividends form the foundation for any prudent investment strategy. Not only do dividends provide a steady passive income stream, but the companies which pay them are also stronger, steadier and better able to weather tough storms. For investors who wish to shift from an aggressive to a more conservative investment style, they should definitely focus their attention on dividends.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.