At NaviCom International Investment we believe that dividend stocks and value investing form a great partnership as week look to meet a specific criteria during our stock selection process.
As investors that follow a value investment philosophy, we are forever searching high quality companies that are undervalued to their potential. Locating these assets is an efficient way of increasing the return on your investment and therefore highly rewarding for your efforts.
Markets determine stock price movements
The price of a stock as you see it today is dictated by the willingness of people who are actively trading the stock. Buying and selling is driven by the activities of the business and more specifically news of those activities. Whether the news is good or bad, price fluctuations in the price of a stock impart a short-term impact. These short-term price fluctuations have very little impact on the company when we look at performance over the long-term.
Trading on short-term positions is comparable to living on the edge. It may be exciting but the risks involved can be catastrophic. As value investors we do not consider short-term price fluctuations as a signal to buy or sell. We are only interested in the true value of a company, and even then, we are only interested if the price is lower than the true value.
The difference between the price and true value is where the value investor is able to acquire a margin of safety. Not only is the value investor positioned to capitalize on much higher returns, he or she has acquired a stock that is less susceptible to market risk.
This lower risk, higher return scenario is where the value investment philosophy becomes a priceless commodity to own, especially as we consider the unstable position of global economy teetering on the edge of another financial crisis.
Dividend stocks and value investing
Besides acquiring a built in risk mechanism, stocks that conform to the value investment criteria more often than not reward investors with high dividend yields. Looking for stock opportunities whose dividend distributions have been historically consistent above 3% is an indicator that the company is value driven.
That is not to say that overpriced companies do not offer value, many do. What I am saying here is that if you are actively investing and you follow the value investment criteria, you will be automatically rewarded by higher than average dividend yields.
Why is this you ask?
It is again because of difference between the company's stock price and it's true value. If the company's stock price is trading below it's true value then the dividend yield ratio immediately increases.
Take this as an example: You identify a company that has distributed a dividend of $0.75 cents per quarter. The company's stock price is trading at $100 per share and therefore offers a 3% dividend yield. You take a deeper look into the company and determine that at $100 per share the company is trading at its fair price. This does not present the value investor with a sound investment.
Now imagine that you come across the same company but this time it is trading at $60 per share. A closer look into the financials tells you that the true value of this company is $100 per share. The company is still offering a quarterly dividend distribution of $0.75 cents, increasing the yield return to 5%. (0.75 x 4) / $60 = 5%
In the above example it is easy to see how undervalued stocks can provide higher dividend yields. This is in addition to the risk factor benefits and potential for higher returns.
Be wary of dividend traps
As with all areas of your investment decision making, you need to be wary of dividend stocks that offer above average yields. We mentioned earlier that a company that demonstrates the ability to payout 3% plus dividend yields could be a candidate for a value investment.
We also mentioned that although a 3% plus dividend may signal value, you will need to dig deeper into the financials of that company to find out what is going on. Do not fall into the trap of being presented with high dividend yields and low prices. There is more to this conundrum than appears on the surface of things.
Extremely high dividends, upwards of 6% are simply unsustainable for any value driven business to maintain. Inevitably, as the company is forced to cut its dividend payments, the percentage yield also takes a hit. As a knock on effect, what we typically see here is a stock price that enters free fall as investors run for the hills.
With this in mind, in your quest of uncovering value stocks based on their ability to pay above average dividends, focus on a dividend yield that ranges between 3% and 6%. Anything less than 3% would indicate that the stock price is fair or overvalued. Anything above 6% is simply unsustainable and will cost you as the stock price tumbles.
Dividend stock investment checklist
So far we know that companies paying above average dividend yields have the potential to become a value investment. Here is a checklist that will help you to determine further whether a company's dividend policy conforms to our value investment philosophy.
Companies that have a competitive advantage possess the ability to generate cash year after year. Looking for high quality companies that demonstrate a history of financial stability, revenue growth and profitability are likely to have an advantage over its industry peers. Checklist: The company has 25 years of consistent dividend payments without a reduction
Conservative distribution policy
I know we are looking for great companies that pay an above average dividend, but we are also looking for sustainable companies whose management also considers market risk.
We like companies that are responsible to their shareholders in the form of dividend payments. However if a company pays out the majority of its income in shareholder dividends they essentially forfeit their margin of safety within the economic cycle. As markets enter a downturn, the attractive dividend has to be reduced. We mentioned earlier the knock-on effect of yield reductions and how they can a plummeting stock price.
Looking for companies that adopt a high yield low payout ratio strategy may be more conservative but will almost certainly outperform a company policy that prefers a low yield high pay out policy. Checklist: High yield / Low payout dividend yield policy
Adjusted for inflation
Many investors look to dividend stocks as a supplement source of income. Keeping a firm eye on the rate of inflation and how great companies adjust their dividend policies to accommodate it can help to identify a winner. Checklist: History of rising dividends to align with inflation
Knowing when to sell As value investors we prefer to hold our stock positions for as long as we can. However there does come a time when we have maxmized our gains as the market inevitably raises the price. If the price extends towards the reals of being overvalued, it is time for you to take your profits and reinvest them into another value position.
You may be reluctant to do so, especially if the stock is still paying an attractive dividend. However think about what we have touched on several times before. Overvalued stocks paying high dividends will be forced to reduce their yield. Therefore not only will your dividend payout reduce, the stock price will tumble taking your value gains with it. Checklist: Price has matured beyond fair value and dividend yield is reduced
There is no doubt that high dividend paying companies are an asset to your value investment portfolio. Make sure however that you are not sucked in by an attractive percentage yield alone. A deeper look at the financial will help you to determine whether the dividend yield is sustainable or on the verge of reduction and stock price collapse.
Incorporating dividend stock and value investing strategy conforms perfectly with the value investment philosophy. We find great companies, hold them for the long-term and re-invest our dividends back into the company to compound the returns.