Can you have too much income?
For most of us, that might sound like a pretty daft question. Who wouldn’t want a bit more money in their pocket?
When it comes to the markets, though, the answer is not always so obvious. Sometimes too much income is not a good thing.
Now, coming from the editor of an income newsletter, Total Income, you might think I’ve completely lost the plot. But let me explain.
It’s not all about yield
If you’re on the hunt for income, you’ll be tempted to look for companies with the highest yield.
At first glance, a higher yield looks more attractive. However, there are a number of things you need to consider before investing.
Because dividends are historical, the yield is not always accurate. If a share price sinks, using past dividends will artificially inflate the yield — especially if the company cuts dividends in the future. This scenario is a ‘yield’ trap.
However, yield traps aside, companies that pay out a big chunk of their profits in dividends — even if they can maintain them — might be doing so for all the wrong reasons.
Perhaps they are doing it simply because they have run out of ideas. They don’t know where to invest surplus funds, so they hand it over to their shareholders.
And shareholders certainly don’t mind. What’s not to like about a juicy dividend coming their way?
However, if companies are paying out too much in dividends, it can harm their prospects. While the yield is attractive, not enough is going back into the business to help it grow.
If you invest in companies like this, it can harm your prospects too. Because if it’s paying out too much of its cash, the share price is likely to go nowhere too.
What’s more, if its payout ratio gets unsustainably high, it will have to cut its dividend. And when that happens — as shareholders in Telstra Corporation Ltd [ASX:TLS] are only too familiar — the share price can take a beating too.
Getting the balance right
Rather than just focusing on yield, investors need to look for a company that is growing. A corresponding increase in profits, along with revenue, is where many investors start.
However, one of the biggest things we look for at Total Income is free cash flow. That is, companies that can grow their cash pile after meeting all commitments. And that they generate sufficient cash to comfortably meet their debt.
If a company can consistently grow its free cash flow, it gives it much more ability to increase its dividends over time.
Hot sectors will come and go. However, it’s a company’s ability to generate cash (and dividends) that ultimately determines its value.
Another type of yield trap
While investors might be aware of the yield trap I’ve already mentioned, there is another trap they need to avoid. That is, avoiding stocks in which the yield is too low.
For example, if you are an income investor, would you consider investing in a stock that trades on a yield of 3%?
If you only assess it based on the yield, the answer is likely a resounding ‘no’. You’ll find a string of other stocks that pay a higher yield than that.
But avoiding stocks with seemingly mediocre yields might prove to be a mistake. What might be a dud yield now might not be in the future.
To show you what I mean, look at the following dividend chart for Sonic Healthcare Ltd [ASX:SHL] — a long-term member of the Total Income buy-list.
Dividend growth — Sonic Healthcare
Source: Sonic Healthcare
[Click to enlarge]
If you go all the way back to 1994, Sonic paid out a total of 2 cents in dividends. Back then, Sonic traded between 50–60 cents per share. At the time it was a pretty unremarkable yield.
However, within five years, Sonic’s dividend increased to 14 cents. Those that bought in at 60 cents were enjoying a yield closer to 25%. And as you can see, dividends have increased steadily since then.
And because Sonic hadn’t overstretched itself, it didn’t have to cut dividends in the thick of the subprime disaster (circled in red).
However, even if you go back only five years from the present, Sonic paid a total of 59 cents in dividends in 2012. This year, its dividend was a total of 77 cents — a handy 30% increase.
Of course, not every income investor can wait years for a dividend to grow. But if a company is growing dividends sustainably, often the share price will follow too. And by being patient, an investor can enjoy both income and share price growth.
All the best,
Editor, Total Income