Smart investors like dividends for a whole range of reasons. High yield shares have been found by many studies to beat the market in the long-run, and that’s reason enough – but a steady trickle of income can make the task of investing much more enjoyable.
People used to think that dividends were dull, but not any more. Quite frankly, I’m not surprised that so many other investors are looking in this direction; it’s only natural that people turn to high yield shares when high growth shares are few and far between.
The problem is that when investors look at dividends, they often look only at the sizeof the dividend. It’s like a fishing lure that pulls them in. And that’s dangerous.
Very high yield shares have a tendency to quickly become NOT very high yield shares. Sadly, this isn’t because the share price leaps upward, helping the astute investor to get rich quick. No – it’s usually because the dividend gets cut and then, in an instant, the whole reason for buying the shares in the first place goes up in smoke (followed by the share price going down the drain).
A recent research note from GMO, the global investment management firm headed by Jeremy Grantham, picked up on this unpleasant truth (this is the same note that I referenced when I wrote about Defensive Stocks recently).
The authors, Chuck Joyce and Kimball Mayer, found that investing in a basket of shares where dividends were not covered by earnings was a bad idea. The portfolio had an annual return of minus 2.6% over the last 30 years or so. Hardly a stellar performance.
On the one hand then, there is a lot of research which says that high yield shares are likely to beat the market in the long-run, but on the other hand, high yield shares can perform terribly.
Here are two things to look for which may reduce the risk of your dividend shares falling flat…
Look for high yield shares where there is adequate dividend cover
This is a quick and simple test that rules out the most risky dividend shares immediately. In most cases, investors like the dividend cover to be at least one, and often even higher… perhaps one and a half to two times at least.
The fact that earnings are greater than dividends…
