How to Invest in Dividends, According to Morningstar's AI Bot

Dividend investing is very popular, but carries inherent risk. Heed the words of Mo, our AI-driven beta research assistant!

Fernando Luque 8 January, 2024 | 11:22AM
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Mo

Disclaimer: Mo is a beta version AI research assistant built on the Morningstar Intelligence Engine that can answer questions using Morningstar articles and research. Mo is designed to surface and summarise Morningstar's independent insights in a digestible format for investors and investment professionals. Mo cannot give investment advice. Like other AI, Mo sometimes get facts wrong. Always check the facts yourself before acting on them.

Fernando Luque: Hello Mo. Today, I would like to talk with you about dividends. Many investors are attracted by them. What would you say to them?

Mo: Dividends can be an attractive investment strategy for many investors. Dividends are cash payments made by a company to its shareholders, typically on a regular basis. They can provide a steady stream of income and can be particularly appealing for income-focused investors, such as retirees, who rely on regular cash flow from their investments.

Dividend-paying stocks can also provide a cushion during market downturns, as the income from dividends can help offset potential losses in the stock price. However, it's important to note that not all companies pay dividends, and dividend payments are not guaranteed. Investors should carefully consider their investment goals, risk tolerance, and the financial health of the company before investing in dividend-paying stocks.

What Affects The Payment of Dividends?

FL: Ok. What economic and market factors may affect the return of this strategy?

Mo: Factors that affect investment strategy returns include value, momentum, quality, small size, low volatility, and investment costs. These factors have been extensively researched and have shown to have a positive impact on long-term returns.

Additionally, factors such as risk, behaviorally-driven mispricing, and institutional frictions can also affect investment strategy returns. It's important to focus on factors that can be controlled, such as fees, tax efficiency, diversification, portfolio risk, and investor behaviour. However, it is important to note investment returns are subject to inherent uncertainty.

FL: Is it true that a dividend strategy gives better long-term results than the market?

Mo: There is no clear consensus on whether a dividend strategy gives better long-term results than the market. Some experts believe that strategies focused on growing dividends are likely to hold up better, while others caution that investors need to consider factors like payout ratios, current yield, and financial health metrics to ensure the right balance between income and quality.

Additionally, the performance of dividend stocks can vary depending on the specific approach and market conditions. Further research and analysis would be needed to determine the effectiveness of a dividend strategy compared to the market.

FL: What financial indicators should I consider when looking for investments with solid dividends?

Mo: The financial indicators for evaluating companies for solid dividends include an Economic Moat, a history of increasing dividend payments, positive consensus earnings forecasts, reasonable payout ratios, and a high dividend yield. Companies with wide Economic Moats are more likely to maintain their dividends during recessions. Dividend cuts or eliminations are often a sign of financial distress. Additionally, companies that consistently grow dividends and have a history of doubling dividends over 10 years are considered favourable.

Can I Evaluate Likelihood of Consistent Dividends?

FL: And can I evaluate the stability and consistency of a company's dividends?

Mo: To evaluate the stability and consistency of a company's dividends, you can consider the following factors:

1) Economic Moat: a company's competitive advantage, or economic moat, is an important metric to assess the stability of its profit stream. Companies with a wide or narrow economic moat are more likely to maintain their dividends during recessions compared to companies with no moat.

2) History of Dividend Payments: a company's history of consistent or growing dividend payments demonstrates its willingness and ability to return capital to shareholders. Companies with a long track record of stable dividends are more likely to weather turbulent markets and maintain or increase their dividend payments.

3) Stock Weighting Approach: weighting stocks by market capitalisation can reduce risk as larger, more mature, and profitable companies are given more weight in the portfolio. This approach helps to avoid stocks with deteriorating fundamentals. On the other hand, weighting by dividend yield increases exposure to stocks with consistent or increasing dividends.

4) Dividend Trend and Company Guidance: analysing the trend of a company's dividend payments over time can provide insights into its dividend policy. Additionally, monitoring company announcements and guidance on dividend distributions can help investors understand the company's direction and potential reasons for dividend cuts.

5) Consensus Earnings Forecasts and Payout Ratios: Companies with positive consensus earnings forecasts from analysts and reasonable payout ratios (below 75%) are more likely to sustain their dividend growth. High payout ratios indicate unsustainable dividends.

FL: What are the best stocks for a dividend-based investment strategy?

Mo: The best dividend stocks for an investment strategy are those with durable dividends and [those that are] undervalued. It is important to be selective and not simply chase high yields, as that can lead to troubled areas and unsustainable dividends. Investors should screen for dividend durability and reliability. Additionally, it is suggested to focus on companies with supportive management teams. The specific stocks that meet these criteria are not mentioned in the provided information.

FL: Is a dividend strategy suitable for every investor?

Mo: A dividend strategy is not suitable for every investor. While dividend strategies can provide income and potential growth, they also come with risks. Some dividend strategies prioritise dividend growth, while others prioritize current income. Aggressively chasing high yields can be risky, as it may involve investing in companies with deteriorating fundamentals.

Additionally, a narrow focus on dividend growth may result in low current yields. However, there are dividend strategies that offer above-market yields while mitigating risk. It is important for investors to consider their individual goals and risk tolerance when deciding if a dividend strategy is suitable for them.

What do I do in The Bad Times?

FL: To finish…a difficult question: how would you manage a dividend-based investment portfolio in difficult economic periods?

Mo: To manage a dividend-based investment portfolio during difficult economic periods, it is recommended to follow these strategies:

1. Buy securities with a safety margin: look for securities that are trading at a significant discount (at least 10% to 15%) compared to their estimated fair value.

2. Diversify your portfolio: securities with high dividend yields are often concentrated in a few sectors with weak long-term growth prospects. A well-diversified portfolio can help absorb the impact of a dividend cut from a single company.

3. Stay informed about events that may affect dividend policies: keep track of any events that could impact the dividend policy of companies in your portfolio, such as excessive borrowing for acquisitions or increased competition.

4. Consider positive scenarios: don't focus solely on recession impacts. Prepare for positive scenarios as well and ensure that you are taking the right amount of risk to reach your goals.

5. Invest in a diversified portfolio: a diversified portfolio with assets that behave differently during a recession, such as equities and high-quality bonds, can help mitigate risk.

6. Lead the economic cycle: adjust your asset mix based on different phases of the economic cycle. For example, during accellerating growth, focus on high-yield credit and developed market equities. During a recession, shift towards interest rates and precious metals.

FL: Ok. Thanks Mo for your help.

Mo: You're welcome! If you have any more questions, feel free to ask.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Fernando Luque

Fernando Luque  is Senior Financial Editor at Morningstar Spain 

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