Why people look for dividend-paying stocks?
Financial independence or a complement for public pensions. These are the main reasons why many investors choose dividend-paying stocks as their core investments. A very common rule to select those stocks is the dividend yield, which is basically:
Dividend yield = latest dividend payed / current price.
Following this criterion, one should have in the portfolio those stocks with the highest dividend yield. In fact, here in Spain we have the IBEX Top Dividendo. This index matches exactly this strategy, so one could replicate it and make periodical purchases. In bolsamadrid.es you will find the index composition for the current year, where you can find dividend yields ranging from a 3,54% (Merlin Properties) to a 7,70% (Saeta Yield).
Like all strategies, it has its own pros and cons. On the one hand, it is quite simple and has very low maintenance costs since it only needs adjustments once a year. Furthermore, you don’t really need to understand about finance and financial analysis. These facts make this strategy suitable for those investors who want to invest but don’t have the time or knowledge to follow more demanding strategies. You only need to trust the formula. On the other hand, if we are planning our retirement, we need to look a little further. In fact, we should include in our portfolios those companies whose dividend is sustainable, regardless their dividend yield. Otherwise, we can suffer from dividend cuts or decreases which could seriously affect our future income.
I have constructed the Praxeos P-score that measures dividend sustainability and takes values between 0% and 100%. Afterwards, I have calculated the four quartiles with the intention of measuring the dividend sustainability among those groups. The results are the following:
Backtest of the strategy
I have formed a group that goes from MAX to Q3 and I have calculated the average payed dividend. I have also constructed another group with the companies scoring below Q3 until the minimum value, which is zero, and calculated the same average dividend payed. In the following table, we can see the different behavior both groups have had during the last eleven years:
From the previous graph we can extract the following two conclusions:
- We can suffer from dividend reduction during crisis periods, no matter what companies we buy.
- On average, we can benefit from selecting those companies with more sustainable dividends.
Besides, the compound average growth rate for both groups have been a 2,9% for the top quartile and a 0,1% for the rest.
Here in this article, we have presented a different criterion to select core investments when we are interested in dividend paying stocks. Nevertheless, from a value point of view, I would not recommend ignoring the price factor. Since we will eventually sell stocks whose dividend sustainability has decreased, paying a reasonable price will help us to avoid high capital loss, that can also harm our future income.