How easy is it to try and set up sizeable dividend streams by investing in high-yield shares?
Some people may simply look at a table listing current dividend yields and start from the highest ones. But that approach can be fraught with risk, for reasons I explain below.
Look at the source of dividends
One reason some shares offer a high yield is because their price has been marked down by the City in expectation of a possible dividend cut.
No dividend is ever guaranteed to last. Some cuts come out of the blue completely, or are announced as part of a wider raft of unexpected bad news.
But other shares offer plenty of clues that their dividends may be cut in future.
Things to look for include a debt-laden balance sheet, declining profitability in the core business, free cash flows below the cost of the dividend, and management reshaping a firm’s capital allocation policy.
One of those factors alone can be enough to trigger a dividend reduction or cancellation.
So I always look at the source of a company’s dividend payments. How is it making the money it needs to fund its dividend – and does that look likely to last?
Don’t ignore the share price
One common mistake is focusing just on yield, not on total return.
During the time you own a share, the dividends you earn contribute to your total return – but so does share price movement, whether positive or negative.
To illustrate, let’s take a look at B&M European Value Retail.
B&M’s yield is 7.6% — very high both for the FTSE 250 and for the retail sector.
But over the past five years, the B&M share price has fallen 69%. So a shareholder who bought five years ago and sells today would be in the red, despite the high yield.
Stick to businesses you can understand
Even when a business does not generate enough spare cash from its ordinary operations to sustain its dividend, it may keep paying it.
For example, it might sell part of its assets to raise cash, that can then fund a shareholder payout.
That is possible for an operating business to do. For an investment trust it can be particularly tempting, as the asset base is often a portfolio of highly liquid assets like publicly traded shares.
Such a move can bring rewards today, but at a long-term cost. With the complexity of accounting rules, such financial juggling may not always be obvious to the uninitiated.
That is why, like Warren Buffett, I aim to invest in businesses I understand.
Penny share Topps Tiles (LSE: TPT) has its problems, from a housing market that is weakening in some areas to supply chain disruption pushing up the price of imports. This month it described market conditions as “challenging”.
The high yield – currently 7.8% — could be at risk. Topps has shown itself willing in recent years to cut its dividend when business results demand it.
But I like that disciplined approach to finances. I also feel comfortable investing in Topps – and have no plans to sell – because I feel I can understand its business.
Its large depot network and digital offering help it sell one in five tiles bought nationally. That gives it a strong basis for long-term financial success.
