Owning a vast portfolio of dividend shares can be a fantastic way to generate a passive income. Unfortunately, simply throwing money into income stocks doesn’t always end well. That’s because dividends aren’t guaranteed. In fact, management teams have the discretion to cut, suspend, or even outright cancel payments.
It’s important to remember that dividends are a method of returning excess capital to shareholders. But should a business land itself in some hot water, excess capital can be hard to find. That’s why most companies tend to cut dividends when economic conditions turn sour, as we’ve recently seen.
Given this risk, it’s no surprise that Dividend Aristocrats are so popular. These are companies that have not only maintained shareholder payouts for decades but also consistently increased them. As such, many consider them to be some of the safest income stocks money can buy. But are they actually a good investment?
The problem with Dividend Aristocrats
The London Stock Exchange is home to a wide collection of income-generating businesses with a multi-decade track record of rewarding shareholders. But looking a the FTSE 100, five companies with some of the longest streaks include British American Tobacco (LSE:BATS), Bunzl, Croda International, DCC, and Scottish Mortgage Investment Trust.
Each firm has been hiking dividends for more than 25 years. DCC is even celebrating its 30th year of dividend hikes in 2024. Needless to say, consistently delivering a higher payout isn’t exactly easy. And that’s where the problem with Aristocrats starts to emerge.
To keep their status, all these firms have to do is increase their payouts. The amount that dividends increase is irrelevant. And looking at the average growth rate of these firms, dividends have only increased by around 4-5% a year. After factoring in inflation, these firms aren’t delivering much in terms of wealth creation.
A question of safety
Not every investor is looking to expand their wealth. Those approaching or already enjoying retirement may be more interested in protecting their wealth. As such, mediocre payout hikes aren’t a deal breaker. But having a long track record of dividends doesn’t guarantee such protections. British American Tobacco is a prime example of this.
Payouts may be on the rise. But since 2017, the share price has more than halved. The company’s facing an increasingly tough regulatory environment surrounding tobacco-based products worldwide. As such, it’s already begun to pivot into alternative products. But the jury’s still out on whether they’ll be able to fully replace current tobacco sales at the same profit margin.
While the early results are encouraging, if the firm cannot adapt fast enough, its multi-decade streak could soon be coming to an end.
The bottom line
Just because Dividend Aristocrats have a reputation of being safe, that doesn’t guarantee them to be sensible investments. Like every stock, investors need to spend time carefully analysing a firm’s current financial position as well as future prospects. Otherwise, it’s easy to fall into an income trap.
