Image source: Getty Images
A common way to try to build income is to buy dividend stocks. But dividends are never guaranteed – and even if they are paid, movements in share prices can affect the overall return from a given investment. So, when I’m looking for income stocks to buy for my portfolio, here are three things I try to keep in mind.
Ield is a historical snapshot, not a guarantee
If you are looking for stocks to raise money to buy for many investors, take a close look at the company’s dividend yield. But that’s just a small snapshot of what the company has paid out in the past.
There are all kinds of reasons why even a strong company might split. Business performance may be weak. Or the company may be in a cyclical industry such as mining, meaning that cash flow suddenly drops and long-term dividends get axed for the foreseeable future. Or it could be a change in management priorities, using spare cash for a purpose outside of the budget.
As an investor of course I look at a company’s yield when evaluating its shares, but I try to focus more on what I think is the potential future dividend (if any).
Income can come at the price of growth
Those management options are about how to use the remaining cash.
Legal & General it is an income that many investors look to buy when looking to grow their holdings.
Since it is the most productive share in FTSE 100 index, at 8.1%, I understand that.
But over the past five years, the share has increased by only 8%, while the broader index has increased by 59%.
Would the statutory and common share price have performed better if management had used more capital to fund business growth, rather than supporting a cash dividend?
It’s possible, although it’s actually hard to second-guess fictional situations. What we do know is that some companies prioritize dividends at the expense of growth and, over time, it hurts their performance.
When I’m looking for income stocks to buy, I always try to keep that in mind.
Dividend cover news
I also consider how good I expect the dividend to be. I look at income, but I also look at cash flow since dividends are ultimately a cost of capital.
For example, B&M European Marketing (LSE: BME) issued a profit warning last week, saying it planned to cut prices to replace the stock. That can hurt operating cash flow.
In its interim results, ordinary dividends of 3.5p per share were more than offset by diluted adjusted earnings per share of 7.2p. It was also covered, but less comfortably, by diluted statutory earnings per share of 5.2p.
But net capital outflows of £377m were greater than net working capital and investment inflows of £326m. That was not only because of the dividend, but obviously the dividend added another problem to the cash flow.
B&M remains profitable and generates moderate cash flow from operations. With its strong product and large customer base, I plan to continue holding the shares.
However, I am aware that management may have decided that the current cash flow balance could be improved by reducing the total amount spent on dividends.
