American oil magnate John D Rockefeller once remarked that there was only one thing that gave him pleasure. He said it was seeing his dividends come in. So, why would someone as wealthy as Rockefeller be that interested in chump change?
Let’s be brutally honest for a moment. The amount earned from dividends in an entire year is miniscule compared to the fortunes that could be made from day trading. Consequently, there are many investors who disdainfully refer to dividends as pocket-money used for paying their broker’s commissions and stamp duties.
But those who know better will understand why Rockefeller was so excited by dividends. A dividend is tangible proof that the company we have invested in is rewarding us for holding its shares.
At its most basic level, dividends can be a good way of increasing our wealth. It is real cash paid into our accounts, which we can then do with as we wish.
We can spend it, invest it, or reinvest it in more shares in the same company to earn more dividends in the future. The choice is ours, entirely – it is, after all, our money.
Digging deep
On a slightly deeper level, regular dividends from investments can be a sign that the finances of the businesses we have invested in are in a healthy state. It is even better if the company can raise its dividend payout, consistently. That can be a strong indication that the outfit is growing, and that its management has confidence in the company’s future cash flow.
Not all companies pay dividends, though. Some businesses believe that any cash generated from the business should be invested back into the business to finance future growth.
There is nothing wrong with that. But a promise of future growth does not have quite the same certainty as a dividend cheque landing in our bank account.
Some investors, known as income investors, judiciously target shares for their dividend yields.
The yield, which is the ratio of the dividend to the share price, can be easily compared with, say, the returns from savings accounts, bonds, and Treasuries.
Where’s the catch?
Let’s take a typical REIT as an example. Let’s assume that it is expected to pay a distribution of 10 Singapore cents next year. Let’s also assume that its shares currently cost S$2.15.
That would imply distribution yield of 4.7 per cent. Put another way, every S$100 of units we own could result in S$4.70 worth of distributions next year.
This makes it relatively easy to compare the dividends we could receive from the REIT with, say, the interest we could earn from a savings account.
Using the REIT as an example again, we would need to find a savings account paying interest of at least 4.7 per cent to beat its dividend yield. Good luck with that.
It goes without saying that at a time when savers are earning very little from bank interest, dividends can be a more attractive option. But there are risks.
Consider, for instance, other high-yielding shares such as companies in the global oil and gas sector. There was a time when these businesses were thought to be so reliable that we could stick our mortgage on them. Not that anyone should.
A sobering lesson
But it seems that one unfortunate event after another has made them less reliable as a dependable source of income.
The latest of those events is simply that many of them are in the wrong business at the wrong time, as the world takes a dim view of “dirty” energy. It just goes to show that income investing is not risk free.
That said, demand for oil and gas is not going to disappear overnight. Nevertheless, it highlights the importance of properly diversified portfolios. Those portfolios that are diversified should not be too badly affected.
Consequently, it is important when choosing shares for a portfolio to make sure that we invest in a broad range of sectors. This is to spread the risks around different industries.
Admittedly, pure income chasers, especially those of us in Singapore, could end up with a portfolio stuffed full of REITs. It’s true that they are good payers. It’s true that their yields are attractive.
But the risk to both capital and income are too high if we put too many eggs into just one basket. Imagine what would have happened if we had concentrated our portfolios on just banks in 2007. It’s a sobering lesson.
Warren Buffett said: “If you take a cat home by its tail, you will learn a lesson that you will learn no other way.”
The point is, while income investing is generally reckoned to be safer than other styles of investing, there are still risks that we cannot completely ignore.
And part of being a successful investor is being smart enough to address the risks.
Note: An earlier version of this article appeared in The Business Times.
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Disclaimer: David Kuo does not own shares in any of the companies mentioned.
