Despite the FTSE 100 hitting a new all-time high last month, plenty of UK dividend shares are still trading at dirt-cheap valuations.
In some cases, these discounts may be well justified. But in others, short-term economic instability may have gotten the best of investors, creating buying opportunities in the process.
Finding undervalued dividend stocks opens the door to potential capital gains from eventual share price recoveries. But they also provide an attractive passive income stream, especially when yields are currently elevated.
Finding the best stocks
Sustainability and expansion of cash flow are critical factors when searching for income opportunities in the stock market. After all, free cash flow is what funds shareholder payouts.
Suppose a company isn’t generating enough excess capital from operations. In that case, investors can often expect a dividend cut over the horizon.
In other words, even if a yield is impressive today, it may not stay that way in the future. So before investing in the cheapest UK dividend shares around, investors need to spend time working out why they’re cheap in the first place.
For example, let’s say a business has suffered supply chain disruptions, resulting in a missed earnings target. Frustrated investors sell their positions, dragging the share price down while simultaneously pushing the yield up.
Providing management is capable of fixing its supply line, this hiccup in performance is likely only short-term. And, therefore, could present a lucrative income opportunity for patient long-term investors.
However, what if the company also has a large debt pile proving increasingly expensive to service due to rising interest rates? Then the depressed share price may be more justified. After all, wiping out loan obligations can be far more challenging. And if mishandled, high debt volumes can lead to bankruptcy, let alone dividend cuts.
Investing during volatility
With plenty of economic uncertainty plaguing the market today, volatility remains high. Don’t forget in the near term, stock prices are determined almost entirely by investor sentiment. And so, even top-notch enterprises trading at dirt-cheap prices can still fall further on short notice.
Continued downward pressure on companies whose cash flow continues to grow or remains intact creates buying opportunities. But only for investors with the money to capitalise on this volatility. That’s why leveraging the power of pound-cost averaging is often a sensible strategy to adopt during stock market recoveries.
Instead of investing money into dividend shares in a giant lump sum, investors can spread their buying activity over several weeks or months. That way, if prices continue to fall on the back of short-term disruptions, income investors can top up their positions at cheaper valuations. This brings their average cost basis down and pushes their portfolio yield up.
Therefore, while investing during volatility is risky, adopting a prudent investment strategy can mitigate the impact of future downturns.
