Blindly chasing dividends is a poor strategy

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Considered a sign of corporate health, dividends typically demonstrate the ability of a company to make money with some consistency. Dividends also indicate that management is attentive to shareholders and confident in the prospects for the business. But investors need to understand how the dividend is being paid for and where it fits within the capital allocation policy. Otherwise, the blind pursuit of dividends without this fuller perspective can be financially hazardous. 

The latest Link Group Dividend Monitor outlined that total UK dividends soared 14.5% in Q2, a record figure for the second successive quarter, as companies paid out £37.8 billion. On the face of it this is good news for income investors; but these bullish headline figures were boosted by large special dividends and the weakened pound. For investors seeking sustainable and growing income, it is critical to look beyond headline numbers that describe what is happening in the aggregate and to assess the individual company's ability and willingness to support growing payouts. 

Increased focus on dividends have marketers sensing an opportunity. Investment strategies that emphasize dividend payers have proliferated. But the pursuit of dividends without understanding the context in which they were generated can lead to poor performance. For example, a high dividend yield can sometimes be a sign of distress: with a falling stock price as a denominator, yields rise. 

Investors also need to consider if a dividend is the best use of capital. Effective management teams weigh the benefits of returning cash to shareholders against internal reinvestments and potential acquisitions as part of a sound capital allocation strategy. If projected returns for reinvestment or acquisitions exceed the firm's cost of capital, then they should consider making those investments. If they do not, then excess free cash flow should be returned to shareholders.

Hence, investors need to know where dividends come from. Are they getting a return on their capital, or a return of their capital? The only way to be sure is to learn how much free cash a company generates. The next and more difficult step is to gain confidence that cash can be produced with transparency and consistency. 

A different picture emerges when dividends, share buybacks and debt repayments - shareholder yield - are viewed collectively as they are all effective forms of returning wealth to shareholders. Using the wider lens of shareholder yield avoids some of the pitfalls of just looking at dividends. If a company is borrowing to fund dividends or share repurchases the net benefit for shareholders is diluted or eliminated. Investors should focus on how much free cash flow is generated and how it is allocated between investments and shareholder distributions, acknowledging that there is more than one way to return value to the owners of the business. 

Ultimately, this re-stresses the case for fundamental research, as only through rigorous analysis will investors come to understand the sources of a company's long-term value creation and how those sources are being nurtured. Identifying companies with clear capital allocation policies, a commitment to transparency, and an ability to consistently grow free cash flow should be the starting point in building a portfolio that emphasizes yield.

Kera Van Valen, managing director, portfolio manager and senior research analyst at Epoch Investment Partners