Dividend shares are popular with passive income investors – and it’s easy to see why. They offer investors a chance to generate better cash returns than they can get from savings.
This, however, isn’t the real reason dividend stocks are brilliant. The cash they return is the bit a lot of investors see, but the real magic goes on behind the scenes.
Passive income
Stocks like Unilever (LSE:ULVR) are popular choices with passive income investors and it’s easy to see why. The firm has a strong long-term record of consistent dividend payments.
Over the last 10 years, the company has returned £14.14 per share in dividends to investors. Based on where the stock was trading a decade ago, that’s a 47% return – or 4.7% a year.
This might not sound spectacular, but UK interest rates back in December 2015 were 0.5%. So Unilever’s dividend returns have far exceeded what someone could have got from cash.
This, however, isn’t why the stock has been a great investment over the last 10 years. Investors have certainly done well, but the impressive bit is how the firm has generated these returns.
Warren Buffett
One of the things Warren Buffett emphasises about investing is that the thing to focus on is the underlying business, not just the stock. And I think something similar is true of dividends.
The reason Unilever has been a great investment isn’t the fact that it has consistently paid dividends to shareholders. It’s the fact that the company has generated the cash to do this.
With dividend stocks, investors often concentrate on the cash coming out of the business. But the important bit is the cash going in – that’s where the returns ultimately come from.
Unilever’s impressive dividend record is a reflection of the firm’s unique competitive strength. And the question investors need to focus on is how durable this might be going forward.
Competitive strengths
Unilever operates in a challenging industry. Customers can switch from one product to another very easily and this creates an ongoing threat for the firm to contend with.
Importantly, though, the company has some outstanding brands and a vast distribution network. And investors can see the effects of this in the firm’s financial performance.
According to its latest results, Unilever generates £8.9bn in operating income using £9.6bn in fixed assets. That’s a 93% annual return on its investments in property and equipment.
Compared with the likes of Kraft Heinz (62%), PepsiCo (39%), and even Procter & Gamble (85%), that’s outstanding. So the question for investors is whether or not this can continue.
Where the magic comes from
There aren’t many ways to earn a 93% annual return on investments in property, plant, and equipment. And this is what drives Unilever’s ability to pay consistent dividends.
Finding a company that can do this – or something like it – is crucial for dividend investors. Whether it’s growth or passive income, this is what matters over the long term.
This comes down to finding businesses with unique strengths. And while Unilever is one example that’s worth considering, it’s not the only one.
