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Dividend stocks: why I think Terry Smith’s advice could help you retire rich

I’m a dedicated income investor who only buys dividend stocks. But my portfolio income will take a battering this year due to the widespread dividend cuts we’ve seen since March.

I’m keen to see if there’s anything I can do to improve my portfolio performance in future crashes. So I was interested to see an article by star fund manager Terry Smith in the FT this week which noted “the folly of investing in equities for income”.

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Am I really stupid, or is Terry Smith wrong?

Terry Smith runs the Fundsmith fund management business. Since its launch in 2010, the Fundsmith Equity Fund has risen by more than 300%. That’s a pretty impressive track record.

Mr Smith makes two main points about dividends. The first is that many FTSE 100 companies have been paying unsustainable dividends in recent years. I think this is a fair criticism.

At the time of writing, the FTSE 100 has a dividend cover level of 1.5. In other words, companies are paying out an average of 66% of their earnings as dividends. This leaves only 33% of earnings to reinvest in growth or repay debt.

In truth, cover is much lower for some big dividend stocks, including dividend heavyweights such as Vodafone, BP, HSBC and Royal Dutch Shell. HSBC and Shell have already cut or suspended their dividends. I suspect we could see more big casualties over the next year.

Dividend stocks I’d buy for long-term income

Mr Smith’s suggestion is that investors who want to buy dividend stocks should look for companies with higher levels of dividend cover. He’s also keen on businesses with controlling family ownership, where management often takes more care to ensure the dividend is affordable.

I’ve hunted through the FTSE 100 and FTSE 250 to find companies that tick these boxes. Here’s a selection:

Company

Comment

Schroders

This FTSE 100 asset manager has been in business more than 200 years and has a reputation for stability and long-term focus. I see this as a great dividend stock — I’d buy the SDRC shares for extra yield.

Associated British Foods

ABF owns fashion retailer Primark, plus a range of food and sugar businesses. It’s still managed and controlled by the founding Weston family.

The dividend has just been cut for the first time since 1988, to reflect the challenges facing Primark. This is disappointing, but I expect the payout to return and still rate this as a dividend stock.

Hargreaves Lansdown

This fund supermarket and retail broker isn’t a multi-generational business (yet). But profitability is superb and founders Peter Hargreaves and Stephen Lansdown still own 33% of the shares.

Hargreaves Lansdown offers a 3% dividend yield at the moment. I think it’s maturing into a good dividend stock.

easyJet

The popular budget airline is facing difficult times at the moment. There are certainly no dividends on offer.

However, founder Sir Stelios Haji-Ioannou and his family still control 33% of the shares. They seem likely to support any refinancing that might be needed.

Mr Smith could help us get rich

Most of these dividend stocks have delivered above-average returns for long-term shareholders. And if you hunt through the FTSE 250 and AIM markets, you’ll find more such firms.

I reckon that following Terry Smith’s advice on dividends could definitely boost your future profits. Personally, I’m using the stock market crash to buy more high-quality defensive dividend stocks for my portfolio. I think Mr Smith would approve.

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Roland Head owns shares of Royal Dutch Shell B. The Motley Fool UK has recommended Associated British Foods, Hargreaves Lansdown, HSBC Holdings, and Schroders (Non-Voting). 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.