For investors who love dividends, 2024 looks set to be a terrific year for income stocks. While the stock market has already started to rally from the recent correction, plenty of dividend-paying enterprises continue to trade at low prices. As such, it’s possible to snap up some chunky yields without having to take on excessive risks.
It’s not just the FTSE 100. The FTSE 250 also houses some impressive payout opportunities for income investors. And collectively, approximately half of the UK’s flagship indices are offering more than a 4% yield, with roughly 60% of firms offering payouts in excess of 6%!
However, now that confidence is returning to the markets, valuations have started to rise again. The FTSE 250 as a whole has already climbed more than 15% since last October. And as stock prices rise, locking in these higher yields becomes more challenging.
Avoiding yield traps
As fantastic as a 6%, 7%, or even 8% shareholder payout sounds, some caution is warranted. Don’t forget dividends are completely optional for a business to pay. It’s ultimately down to the management teams. And they may be forced to cut or even suspend payments if the group’s financial situation starts to worsen.
After a company has paid all its operating costs and capital expenditures, the Free Cash Flow (FCF) is what remains. This is the pool of excess funds a business has at its disposal that can be used in a variety of different ways, including shareholder dividends.
Therefore, after being lured in by an attractive yield, investors need to spend time investigating the state of a company’s FCF. If dividends are easily being covered by this excess cash, then the probability of a dividend cut is likely lower. It could even indicate the potential for further dividend hikes.
However, should FCF fall short of requirements, then perhaps a cut is coming. Or worse, the management team may decide to take on debt just to keep up with shareholder payments. Needless to say, these latter two scenarios are a serious red flag.
Diversifying dividends
Even after finding and constructing a portfolio of top-notch income stocks, the quality of these investments may deteriorate over time. Macroeconomic factors are in a constant state of flux, and thriving businesses may end up facing new unforeseen challenges later down the line.
While these threats are largely unavoidable, their impact can be mitigated through something as simple as a diversification strategy. By owning a wide range of quality businesses operating in different industries and geographies, the damage from one being disrupted can be offset by the others.
However, the key word here is ‘quality’. All too often, novice investors rush to buy as many shares as they can for the sole sake of diversification without properly investigating the suitability or quality of these businesses.
This is known as ‘diworsification’ and, in some cases, can easily end up destroying investor wealth instead of building it.
