Investing in dividend stocks can be a great way for you to build wealth over time, and it’s a strategy that’s always been popular here in the UK.
However, not all dividend-paying companies are equal. Before you consider investing in a firm, it’s always worth checking for red flags. So here are some warning signs you should be wary of when thinking of putting money into a company that pays dividends.
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What are the basics of investing in dividend stocks?
Here’s a quick refresher of this type of investment to make sure we’re on the same page. A dividend-paying stock is typically a company that rewards shareholders (people who own shares) with a payment.
These payments are usually made a few times a year and will be dependent on the company’s performance. Although many people use dividends as a source of income, these rewards can vary. A company isn’t obliged to pay you a dividend, even if they’ve been doing so for years.
An income-focused investment strategy can be an excellent way to steadily build wealth and compound your gains over a number of years. But to give yourself the best chance of success, there are certain things you should look out for before you part with your hard-earned cash.
What warning signs you should look out for?
Here are some common red flags you should be wary of when you’re looking to invest in a stock that pays dividends.
1. Unusually high payments
Sometimes, if a stock is struggling, the company will try to entice more funding and investment by offering a high dividend payment.
This can work as a honey trap, sucking investors in with promises of large rewards. But if the company is doing this, it’s important you make sure it’s not an act of desperation or a ‘Hail Mary’ attempt at injecting some cash into the firm.
High dividends are not always a bad thing. Companies will sometimes give out ‘special dividends’ that are like bonus payments. This usually happens after a period of strong performance and it’s something we’re seeing a lot with British dividend shares at the moment.
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2. Cuts to dividend payments
When a company has to slash its payments to shareholders, this can also be a bad sign. Sometimes firms make these cuts if they’re struggling for cash or it’s vital the money is used elsewhere in the business. A couple of recent examples of this are AT&T and DS Smith.
AT&T (T)
Previously AT&T was one of the best dividend stocks with an annual payout of $2.08 per share. Now, it’s cutting this down to an estimated $1.19, marking a 45% decrease. This is not a great sign for income investors. However, this is partly because of brand restructuring and plans to invest the savings into 5G and the fibre network.
DS Smith (SMDS)
This FTSE 100 company has seen its share price decline heavily over the past few months. The firm had been performing well over the last year, but inflation and supply chain issues have increased its costs. As a result, the dividend payment is down from 11p in 2019 to 8.1p in 2021.
3. Profit warnings
This can apply to both dividend stocks and other shares. A profit warning is when a company lets investors know that its earnings and profit may be lower than expected.
Bad news like this can affect a company’s share price and its ability to pay a dividend. So, it could be a sign of more trouble to come.
However, sometimes these profit warnings can just be a temporary blip due to factors outside the firm’s control. Take a profit warning seriously when doing your research, but make sure you’re still looking at the big picture.
How can you find good dividend stocks to invest in?
After reading these potential warning signs to look out for, you may be wondering how to go about finding solid dividend investments.
One of the best places to look is the dividend aristocrats from the S&P 500 in America. Another source of inspiration is the AIC heroes list. Within both of these, you’ll find top stocks with a long history of consistently paying investors.
Whatever dividend stocks you end up choosing, it’s worth buying shares using a top-rated stocks and shares ISA. This way you won’t pay tax on the income that’s generated.
Keep in mind that all investments carry risk. Dividends are not guaranteed, the payouts can fluctuate, and so can the underlying share prices. So you may get out less than you put in.
