Interest rates remain at record low levels. Putting your money in the bank will barely return you more than the rising cost of living.
For this reason, Australians have been piling into our best known dividend paying stocks. Companies like Telstra, IAG, Coca-Cola, the big banks, and listed property trusts.
But just because a company is paying a high yield — for the time being at least — doesn’t mean it’s a quality investment.
Before checking how much a stock yields, you should always make sure that you are buying a quality business. Members of the Albert Park Investors Guild are well aware of just how important this is. That’s why every stock in the Guild’s portfolios has to meet a stringent list of critical criteria before I’ll even consider recommending it to our members.
I’ve explained to Daily Reckoning readers in the past some of what’s involved in identifying a quality investment. You can review that here.
If a company meets all the requirements, then you’re on the right track. Or you might have your own set of requirements that a stock must meet. Either way, you shouldn’t ignore the fundamentals just because a stock meets your desire for income.
A poor quality business won’t be able to maintain its high dividends for long, and you may find yourself in a company with a falling share price.
Additionally, you should scan the company’s financial statements for any nasty surprises. Company financials are easy to get a hold of. They’re available on company websites — on their ‘corporate’ or ‘investor relations’ pages. Once you get in the habit of checking the financials for any abnormalities, they’ll jump out at you.
At times, you might even get lucky and uncover a hidden gem.
That’s just what happened while I was researching a recommendation for the Albert Park Investors Guild.
Initially, I identified a stock that met all the Guild’s requirements. A growing business with an excellent track record, rising revenues, no debt, good cash flow, a high return on shareholders’ equity — it ticked all the boxes.
But I wanted something more. I wanted all of these features — in a company that pays a decent dividend yield.
A quick look on Yahoo! Finance revealed the following:
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As you can see, the company has paid $0.88 in dividends over the past year, for a 1.9% dividend yield.
‘Not exactly impressive,’ you might be thinking. That’s fair. It’s what most investors would first think when searching for yield. And I’d have to agree. At first glance.
There’s actually more to this story — if you’re willing to dig a little deeper.
I can’t yet reveal what the stock is here. That’s something exclusively reserved for our members, and won’t be published in the Guild until Monday. For now, let’s call it XYZ Company. WhatI can show you is how to uncover stocks like XYZ Company that are not appreciated by mainstream investors.
Regardless of the disappointing yield, I took the time to have a look over the company’s financial statements. Again, I urge you to do the same with any and all stocks that you’re thinking about buying.
Looking through XYZ Company’s financials, hidden in the footnotes I found a history of six years of annual special dividends.
Special dividends are typically one-off dividends. Companies pay special dividends when they want to return extra cash to shareholders, but they don’t want to cause a temporary spike in their regular dividend history.
Many income investors choose to ignore special dividend payers, since these dividends are usually bonus one-offs. Income investors want reliable income.
However, there are a select few companies that make a habit of paying special dividends year after year. They’re not easy to identify. You certainly won’t find them by surfing the major financial sites — the mainstream financial press ignore these dividend payments altogether.
Despite what Yahoo! Finance told me — and other leading financial sites including Bloomberg, Google Finance, and The Wall Street Journal — XYZ Company actually has a solid track record of paying generous dividends.
Here are the past six years of XYZ Company’s bonus special dividends:
Over the past six years, these additional ‘special’ dividends have ranged from $1.20 to $4.50 per share. That’s an average ‘special’ dividend yield of 7.4%. Add in the regular dividend yield of 1.9% and you’ve uncovered a company yielding 9.3%!
If past dividend returns are anything to go by, the income alone from investing only $500 in this company could cover a year’s membership to the Albert Park Investors Guild.
Keep in mind that there is no guarantee that, just because a company has a track record of paying special dividends these dividends will continue to be paid in the future.
However, there are a number of factors that will indicate whether the company is capable of continuing to pay these dividends.
Growing revenues and profits: An unprofitable company will be unable to keep paying dividends into the future without negative consequences. If a company’s profits are falling it will be hard for the company to maintain its dividend without growth suffering or going into debt to cover dividends in the short term.
Ability to generate cash flow: Even if a company is profitable, there is no guarantee it can pay dividends. Dividends are paid with cash generated by the company, so make sure that it is a cash rich business.
Mature company: Well established, mature companies are in a better position to pay dividends than are young, growing businesses that need to reinvest their profits for growth.
Avoid dividend traps: If a stock’s share price has recently fallen, it can appear to be high yielding when past dividends are considered. But remember you will be receiving future dividends that are likely to be reduced.
Other signs for shareholders to look for are a history of stock repurchases. Any stock repurchases boost the value of existing shares on issue. Plus, high company ownership by management is a good sign that operating decisions will align with shareholder interests.
Make sure that the fundamental reason why a company has been paying dividends — whether they be regular or special — has not deteriorated.
To uncover sustainable dividend — and special dividend — paying stocks, it pays to do your homework. You can’t expect to make above average returns if you know nothing more than the average investor.
Investment Director, Albert Park Investors Guild