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3 things all income investors should know

It used to be that savers could park their cash in a savings account and wait for their retirement wealth to compound. Not any more. For over a decade, central banks have kept interest rates at unprecedentedly low levels, practically erasing the possibility of living off of cash interest. The net result of all of this is that savers need to find alternatives and high-yield income stocks look like an appealing option.

High yields are a warning sign

But are those yields as appealing as they look? Maybe they’re a sign that the stock is struggling. I find that this thought is something that initially puzzles many people who are just getting started with income investing. How can it be a bad thing if a company is returning a lot of money to its shareholders? Well, it can be problematic on several fronts. Firstly, excessively high dividends can end up being a drain on a company’s cash, which could end up coming back to haunt management in the long term. Secondly, a refusal to cut the dividend in order to save face could be a sign of poor management. 

Most importantly however, an excessively high yield is generally unsustainable, and both the market and the executives in charge of the company usually know this. As a result, high yields are also often a sign of a coming dividend cut, not something that an income investor wants to see.

Search among boring industries

For a company to pay out a regular dividend, it needs a reliable source of cash flow. Typically, the kinds of businesses that pay out good dividends are relatively mature, have built out most of their pipelines and are probably not growing at a particularly fast rate. A company with exciting growth opportunities should be reinvesting capital into itself, rather than distributing it to shareholders. 

Ideally, your income stock should also have a healthy balance sheet with a low debt-to-equity ratio. A business that has to spend a large portion of its cash servicing interest payments is unlikely to have a lot of excess capital to pay out in the form of dividends. Such companies are often found in ‘boring’ industries like utilities, telecoms and consumer staples.

Look for strong dividend growth

Dividend growth is simply the percentage amount by which a company has increased its payout to shareholders relative to the previous period. A steadily increasing dividend is a pattern that should appeal to all income investors, as it shows that the company is well-managed and that executives are converting revenue growth into dividends. 

Moreover, a strong dividend growth rate is also a sign that the value of the business is growing. Income investing is not just about dividends. It’s also important for the company to increase, or at the very least maintain, its current valuation. There’s no point buying a stock with a 10% yield if its value is going to erode over the next five years. Dividend growth is a sign that such capital losses are unlikely. 

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Stepan Lavrouk owns no shares mentioned. The Motley Fool UK has recommended Landsec. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.