Are your stocks paying big dividends? Look out for the warning signs.

Source: studypoints.blogspot.com

When looking at stocks with the aim of income as supposed to growth who offer more downside protection than growth stocks, there are certain characteristics that companies hold which gives an indication that they are more concerned with paying out dividends to their shareholders, rather than keeping the dividend as retained earnings and investing them in growth, jobs and taxes for the economy.

Certain sectors will pay out more dividends than others and this depends of the volatility of their cash flows over the financial year and their operational gearing: if cash flows are volatile then it is less likely that they will pay a dividend and keep the cash to weather out the bad days, these are companies such as mining companies and transport manufacturers.

The Pay Out Ratio

However, there are signs which you need to look out for when companies are promising big dividends and a key metric to look out for is the pay-out ratio. This is the ratio that compares the proportion of net income as retained earnings to the dividends that are paid to stockholders. If this is an excessive figure (I.e. over 100%, where there is a large chance that dividends will be cut) then there is the possibility that the company will have insufficient retained earnings in the future to continue growing and is a reflection of the directors dividend policy.

The pay out ratio should be a leader of the industry or sector, but should be modest and have room for future growth, very few things damage shareholder loyalty more than a volatile divided pay-out.

Cash flows

Looking at the companies cash flows are an essential element of choosing stocks to invest, Companies can operate without cash for a short amount of time, that is, until the bills come rolling in. A steadily growing net cash flow figure is a characteristic in more mature companies where there is little room for growth and therefore investment and is an indicator that the company can manage its cash flows effectively and therefore of less risk to an investor who is looking at receiving steadily growing income from dividends over the long term

A newer start-up company will tend to have negative or declining cash flows as heavy investment (such as the purchase in property, plant and machinery, or significant investment in working capital) tends to be the priority and is very unlikely they will pay put dividends. Small Cap investors can choose funds whose speciality is investing in start-up business through Venture Capital Trusts or Enterprise investment Schemes where tax breaks are available here, but is outside of the scope of this article.

If there is more cash going out than coming in, then there is a very big chance that dividends will be cut or eliminated altogether and send investors to dump the stock and invest elsewhere.

The Bottom Line

If you are looking for income over growth, then your relationship manager will be able to pick out the best stocks which offer the highest dividends yield and pay-out ratios and will apportion your stocks for your portfolio to ensure that your portfolio as a whole will have the best dividend yield possible.

Disclaimer: any mentions of tax breaks only apply to the UK tax system, whereas Europe and the US will have differing tax systems and laws.

Contact the Writer of this Article:

Todd Gilbey | gilbey.todd@googlemail.com

 

Investing in Equities: a Quick Guide for Novices.

Equities are a good hedge against inflation, or in anticipation of rising inflation. If you wish to take on more risk in your portfolio, then equities are recommended. They’re more risker than fixed income (depending on the credit risk of the issuer) but you can achieve higher total returns if gone about the right way.

This article should be of use to pension funds, where UK pension funds have a higher proportion of their assets in equities than in fixed income, compared to Europe, which is the opposite.

When assessing which stocks to purchase, you need to ask yourself the question: is this company going to go into liquidation any time soon? It is obvious that if their solvency is questionable, then stay away from that company. This is because with equity investing, it is the ordinary shareholders which have last grabs of the money in the pot when a company goes into liquidation, after preference shares have been paid along with secure and unsecured creditors, so equities carry the highest risk of financing so therefore, these carry the highest cost of capital to a firm.

You also need to decide if you want income or capital growth objectives for your equities portfolio. Income is generated from dividends paid to shareholders usually twice a year, but note that not all companies pay dividends. Those companies which have volatile cash flows will prefer to retain their cash position to weather out the lean months will usually choose not to pay cash out as dividends. These are usually companies such as mining companies, where discoveries of mining sites are far and few between and so are the cash inflows brought about by those discoveries.

The way in which to screen stocks which are worth investing in are not by purely going for the well-known companies, such as Apple, Tesco’s and Ford, even though they have little chance of failing over the new few years, there could be lawsuits, product failings and management fall-outs, all of which can send waves of panic throughout the investment community. I hold stocks of companies which I’ve never even heard of until I invested them. You shouldn’t merit a company by how famous it is, you should merit a company by their ability to be solvent. Here is a simple guide to how I do this:

Cash flow growth

Cash flow is the vital lifeblood of any business. A business without cash can continue trading for a short while, that is until the bills come rolling in. From that point onward, a company is deemed insolvent and petitions can be brought up against the company with the result of it either going into administration or liquidation, depending on the type of creditors putting the petition in place.

Look for strong year-on-year cash flow growth, there may be years when cash flow is declining, but on average, if cash flow is growing then you’ll be in with a good chance of owning a company that is solvent and is a good indicator or their ability to generate cash as and when needed.

Net Shareholder’s Fund Growth

Just like you want to look out for cash flow growth, net shareholder fund growth is also important too. If this figure is growing, this means that a company’s assets are exceeding their liabilities year-on-year and so are able to take more losses before they are insolvent. In other words, they own more than the value they owe to lenders. A negative balance means they owe more than they assets they own, which is used to determine if a company is insolvent.

Profitability

Of course, you want to invest in companies whom have strong profits; especially of you want to receive dividends. Note that profits do not necessarily mean cash. A sale can be made when an item is sold on credit and so the cash received from that sale can be at a later date. Most financial accounts are prepared on an accrued basis, which means that profit and cash are not the same thing. Cash is the hard stuff which is used to pay bills, whereas revenues are sales generated both on credit terms and on cash terms and the profit generated from those sales are revenues minus expenses. A business can be very profitable but almost bankrupt at the same time, because cash may not necessarily be collected from those sales. This is why I said earlier that cash flow is just as important, if not more important, as profitability.

Income or Growth?

Looking for stocks which provides a decent stream of income will mean owning a portfolio of stocks which have a high dividend yield than the markets or sector. Your portfolio manager will allocate stocks to enable the highest weighted average dividend yield for the entire portfolio if this is what you want. Dividends are usually paid twice a year and are made up of interim dividends and final dividends which will give the total dividend paid or the financial year. If you are looking for funds which pay a steady stream of income, look for funds which have the suffix ‘Dist.’ or ‘Inc.’ which means that dividends and interest is paid straight out to the fund holders instead of being reinvested.

Credit Rating, low cost steady supply of resources, management skill and product innovation: all of these are essential elements also when looking to purchase stocks in a company. If the company purchases commodities on the open market, especially if at the spot price, the volatility of price fluctuations can seriously hurt a company’s cash flow and profitability. Most companies will have their own hedging policy, meaning they enter into a contract with a counterpart to purchase or sell a specified amount of commodities, such as oil or steel, at a price determined now, but to acquire the stock at a later date and thereby gaining certainty as to the price in the future, regardless to the spot price at the date when then stock is actually acquired.

If you are interested is investing in stocks, speak to your relationship or portfolio manager to discuss your needs and liquidity preferences. You will need to have a clear idea of your risk tolerance and the risks associated with investing in such instruments. It may be better to invest in equity funds that are professionally managed by a portfolio manager, and will achieve the benefits of diversification and allocation timing based on current economic conditions.