Find out how Income Investing approach works.
Putting dividends first to secure sustainable income returns
An approach for the conservative investor, investing for income-generation can be achieved through selecting cash equities that pay out high and regular dividends.
There are two ways to profit from holding cash equities:
- Share price appreciation
- Dividend income
The attraction of this style of trading is its passive and low-risk nature, in which capital appreciation is a secondary objective behind sustainable income generation, and capital is typically preserved (though not guaranteed) within a defensive portfolio.
This sort of long-term protection is appealing if you are a conservative investor. Unlike growth investing, which focuses on capital gains through share price appreciation, income investing shares similarities with a buy-and-hold or value investing, where the aim is to generate capital appreciation.
Traders using an income approach screen for stocks with strong finances and reliable profits, which have a culture of returning 'excess' profits to their investors in the form of reliable dividends.
Such dividend payments, which are made annually or more regularly, often prove resilient even in periods of economic weakness or difficult trading periods for that company, making them a stable source of income. In an economic recovery, these companies make higher profits, increasing the amount they can pay to shareholders in the form of dividends.
Listed companies are not forced to pay dividends but high and reliable dividend payers believe that this supports their share price valuations by signalling to the market that the company is financially robust and stable businesses.
A significant proportion of cash equity returns are generated from re-invested dividends, which provide a compound return effect, irrespective of whether the price of the stock rises in value or not.
Reinvested dividends are particularly beneficial during a bear market because more shares are purchased when prices are low in the market. As soon as the market enters a bull phase and prices recover, the return is actually enhanced by the temporary fall in the company's stock price.
Rule of thumb: Sectors renowned for housing high dividend-paying cash equities include telecommunications, utilities, real estate investment trusts and insurers.
Dividend Yield and Cover
Income investors focus on a company's dividend yield as gauge to determine its ability to deliver returns. The dividend yield is calculated by dividing the annual dividend per share (DPS) to the current stock price, giving the actual return that a dividend offers to the stockholder.
Average stocks yield a dividend of around 2-3 percent per share while income stocks usually provide a higher yield of around 5-6 percent per share, making them a preferred choice for income investors.
That being said, there's a note of caution surrounding those companies with dividend yields that are too high, as in many cases, companies are unable to sustain such levels and might need to lower their pay-out ratio.
For that reason, income investors use the dividend cover as a measure of how secure next year's dividend payment is. The dividend cover is calculated by taking the company's profit after tax and interest payments and dividing it by the dividend commitment.
A dividend cover of less than 1 means that the company may have trouble to pay its dividend and might cut it instead, making it high-risk. A cover between 1 and 1.5, would be regarded medium-risk, as it still does not leave the company with ample room to pledge a pay-out commitment. However, a cover above 1.5 is seen as low-risk and most desirable for income investors.
- Stock-picking skills are essential as you must conduct thorough fundamental analysis to identify companies that pay-out high and constant dividends to offer you a return on your investment.
- Dividend payments are subject to tax in the U.K. and in some cases, can be taxed more than capital gains which can reduce your overall return.
Income investing is not exclusive to cash equities. Many investors diversify their portfolios to generate income from high-yielding bonds, multi-asset individual savings accounts (ISAs) and certificate of deposits (CDs).
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