In 2023, cheap dividend stocks offer an alluring mix of generous passive income capability and substantial capital growth potential.
Depressed valuations have pushed yields higher, giving income investors more bang for their buck. And now that economic conditions are improving, rising investor sentiment is lifting stock prices back in the right direction, including boring dividend-paying ones.
Therefore, while there remains uncertainty in the stock market, now could be the perfect time to secure superior long-term gains.
Locking in high yields
A dividend yield measures what minimum percentage return an investor can expect to earn, providing that shareholder payouts aren’t cut, and the stock price remains static.
Since yield is a function of share price, declines in market capitalisation naturally push it up. This allows investors to secure higher payouts with the same amount of capital.
Under normal circumstances, dividend stocks offering a high yield can be a red flag. Why? Because drops in valuation are typically triggered by disappointing earnings or developments that potentially compromise cash flows. And if cash flows are disrupted, a cut to shareholder payouts usually follows.
However, with most valuations in 2023 being dragged down due to weak investor sentiment, a high yield may not necessarily be a warning sign today. Instead, it could be a lucrative opportunity for passive income portfolios.
Having said that, investors still need to perform all the critical due diligence and investigation to verify there isn’t a glaring problem lurking beneath the surface. After all, there’s nothing worse than locking in a high yield only to watch it evaporate a few months later.
Capital gains from dividend stocks
Dividend stocks are usually mature enterprises that haven’t got much going for them in terms of growth. In fact, that’s why these firms pay dividends – the lack of internal opportunities means management teams return excess capital to shareholders.
However, during a stock market correction, things get shaken up. Economic uncertainty creates a misalignment between price and intrinsic value as investors start making emotional decisions instead of logical ones. Loss aversion creates panic selling even among businesses with strong fundamentals.
While it’s unpleasant to watch as an existing shareholder, investors with money at hand can capitalise on this downward momentum. In the long run, once confidence returns to the markets, it’s the sold-off high-quality companies that typically experience some of the largest recovery gains. And, subsequently, a boring dividend stock can end up generating double-digit capital gains.
Keeping risk in check
Cheap dividend stocks can be a lucrative source of returns. But even investing in mature businesses still carries risk. Big businesses are not immune to disruption. And with rising interest rates, those carrying a large debt pile could still suffer margin erosion.
This is just one example of the many threats that investors must consider. But diversification is the tried and tested way to mitigate overall portfolio exposure. By owning a basket of dividend stocks from various industries and geographies, the impact of one position failing to live up to expectations can be offset by the success of others.
