Have you ever looked at a dividend share and thought the yield seemed too good to be true?
Dividends are never guaranteed and often an unusually high yield can be a red flag. It may be that investors think the payout could be unsustainable.
However, it may simply be that the share has fallen out of fashion and turns out to be a terrific long-term bargain.
Low yield can be a weak starting place
Plus, although a high yield can be a red flag, plenty of shares with low or middling yields see dividends cuts too. When I said above that dividends are never guaranteed, I meant for any share.
But there is another challenge with low-yield shares. A low baseline means that even fast dividend growth can take a long time to get to an attractive level.
To illustrate this, compare two shares I like for different reasons: growth share JD Sports (LSE: JD) and dividend share M&G (LSE: MNG).
They yield 1.1% and 6.3% respectively.
Last year, M&G grew its interim dividend per share by 10%. JD Sports’ equivalent was a meagre 1.5%.
Even if JD Sports keeps growing its dividend at 10% per year, it will take 19 years for it just to get to the same yield as M&G now. Along the way, if M&G simply maintains its payout — let alone raising it annually as it aims to do — its shareholders would keep coining in the dividends.
In this example, by the way, I presume share prices are flat, to illustrate the point. In reality, share prices move around, which has an impact on yield. But the broad point, about starting from a low base, is clear.
There’s more to life than dividends
Above, I referred to JD Sports as a growth share and M&G as a dividend share. Their yields make those definitions obvious – but the dividend growth does not. After all, JD Sports’ dividend growth is much higher than M&G’s.
So why do I see it as a growth share?
M&G is a mature business operating in a longstanding industry – we could also call it mature, although in some less-developed markets asset management remains fast-growing.
So M&G could grow significantly, for example by acquisition, but its current business strategy does not focus on that.
In fact, one of its challenges in recent years has been to stop policyholders pulling more money out than they put in to its funds, potentially hurting earnings. That remains a risk.
By contrast, JD Sports has been growing fast, building hundreds of new shops and acquiring overseas chains. In the short term there is a cost to that – the dividend yield is meagre and earnings per share last year actually fell rather than rose.
Over the long term, though, that expansion could help supercharge growth. Or, it could be an expensive mistake that hurts earnings for years. Time will tell.
But, when I invest in a share with little or no dividend, I at least hope for growth.
Making a choice
For me, then, a low-yield share can be fine if I think it has decent growth prospects.
I am also happy owning shares with limited or no growth prospects for their passive income potential.
Either way, I look for a quality business and an attractive valuation.
