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The importance of consistently covered dividends

The Fund Manager

This article goes back to basics and outlines why a consistent record of dividend payments is the first thing I look for in a company, and why dividend cover is the first of many ratios in my investment spreadsheet.

Dividends make up the backbone of my investment strategy, so the first thing I look for in a company is a track record of consistent and sustainable dividends.

If you’re new to investing, here’s a quick definition:

Dividend per share (DPS): Dividends are cash payments made from a company to its shareholders. In theory, cash should be paid out to shareholders as a dividend when the company cannot invest that cash within the business at an attractive rate of return.

There are several reasons why dividends are central to my approach. The most important reasons are:

Dividends support efficient capital allocation

A company should only retain cash generated from operations if that cash can be used to produce an attractive return. The main uses of retained cash are:

  • Maintaining the existing business
  • Organically growing the business (e.g. buying stock or investing in factories, stores or equipment)
  • Acquiring other companies
  • Paying down debt
  • Buying back shares
  • When those options are exhausted, cash should be returned to shareholders as a dividend.

With companies that don’t pay a dividend there is, in my opinion, a greater risk that cash retained within the business will be used to expand the CEO’s empire (and pay packet) rather than maximise returns for shareholders.

Dividends create commitment and accountability

Companies with progressive dividend policies have made a promise to investors that they will maintain or grow the dividend each year.

This provides a public and very concrete goal for management to achieve. Of course this promise can be broken, but on average dividend-paying companies have historically performed better than non-dividend payers.

Dividends are a helpful yardstick

A progressive dividend gives investors a gauge for the long-term progress of a company. While earnings (and to a lesser extent revenues) bounce around from year to year, a progressive dividend can act as a more stable indicator of a company’s underlying growth rate.

Dividends provide investors with a regular income from their investments

Perhaps the most obvious benefit of dividends is that they’re a form of cash income. For investors who want an income from their investments, dividends are an excellent way to receive that income without having to sell any shares.

This removes any confusion around what is or isn’t a sustainable withdrawal rate, because withdrawing dividends should always be sustainable.

Dividends also provide an always-positive return which is independent of a company’s share price. This can help reduce the volatility of your portfolio and provide a positive return even if (heaven forbid) one of your holdings eventually goes bust.

Looking for a long record of continuous dividend payments

Benjamin Graham, the father of value investing, once said that “Each company should have a long record of continuous dividend payments.” The logic behind this rule is simple:

If investors want to buy companies that are likely to pay a consistent dividend in the future, the best place to find such companies is among those that have paid a consistent dividend in the past.

This leads to the first of many rules of thumb which I use to guide my investment decisions:

Only invest in a company if it paid a dividend in every one of the last ten years.

Most companies pay dividends multiple times per year, so if a company missed a single interim or final dividend then that may be okay, as long as some sort of dividend was paid every year. However, if no dividend was paid in one or more years then the company goes straight into my metaphorical waste paper bin.






The Fund Manager

About John Kingham

John Kingham

John Kingham is the editor of UK Value Investor, the investment newsletter for defensive value investors. With a professional background in software analysis, John's approach to high yield, low risk investing is based on the Benjamin Graham tradition of being systematic and fact-based, rather than speculative. John is also the author of The Defensive Value Investor: A Complete Step-By-Step Guide to Building a High Yield, Low Risk Share Portfolio. His website can be found at: www.ukvalueinvestor.com.

Articles by John Kingham

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