To me, searching for safe investments, with a focus on the dividend payment, means looking for a payout that is unlikely to be cut, and which is likely to grow.
To achieve that, the payout needs support from a strong, growing underlying business.
Beware the big yield
It’
s tempting to look for the biggest yields when putting an income portfolio together, but I think that’s a mistake. The biggest yields often signal trouble ahead. For example, huge yields tend to signal imminent trading collapse in the cyclical firms, or that a share price has declined because a firm’s forward prospects look grim.
Investing in a very high dividend strikes me as a risky investment strategy. The chances are strong that a big yield will be trimmed, or stopped altogether, or that it will remain flat, signalling a moribund investment with perhaps more downside risk than upside potential. In such cases, investors could face the double whammy of falling income and shrinking capital.
When it comes to harvesting dividend income as an investment strategy, I think it best to focus on the potential for dividend growth rather than on the absolute level of the yield.
A robust business
Thinking along those lines, one consistent feature of ARM Holdings’ (LSE: ARM) (NASDAQ: ARMH.US) financial performance in recent years is double-digit growth in earnings, which qualifies the semiconductor intellectual property supplier as capable of supporting a rising dividend payment.
It might seem offbeat to think of a company as a dividend investment when the dividend yield is running at about 0.7% for the current year, but ARM’s dividend growth record is impressive. The firm delivered a 24% compound annual growth rate (CAGR) for the dividend, almost doubling the payout over four years, as we can see in the table:
| Year to December | 2009 | 2010 | 2011 | 2012 | 2013 |
|---|---|---|---|---|---|
| Dividend | 2.42p | 2.9p | 3.48p | 4.5p | 5.7p |
Projected earnings for the current year cover the forward dividend almost three-and-a-half times. That’s high cover, which is normal for firms with plenty of growth left under the bonnet, and it implies that if the dividend was notionally rebased for two-times cover, the yield could be running at near 1.3%. That strikes me as a fairer way to look at value through the lens of dividend for a growth company.
Looking ahead
Assuming ARM keeps its business growing it seems reasonable to expect dividend growth too. Let’s say that instead of achieving a CAGR of 24% as it has, ARM manages to grow the dividend by 20% a year on average.
On that basis, the payout will be just over 14p in 2018, which delivers investors an almost 1.5% yield on today’s share price of 966p. If we then notionally adjust for earnings’ cover of two, the yield could be in excess of 2.5%, which starts to look like handy income for investors. There’s also potential for share price gains to increase investors’ capital over the period as well.
What now?
If ARM can keep growing for a decade or more, the sums become even more interesting. So is ARM Holdings a safe dividend investment? Yes, I think it could be, and it seems valid for investors to justify an investment in the firm by looking at the strength of its dividend.
