One way to start building a valuable equity portfolio is to find good dividend yielding stocks, says Tony Morgan. But there are many things to consider to get the reliable income stream you are targeting

The prospect of receiving a dividend, be it paid quarterly, half yearly or annually on a recurring basis, seems a logical enticement for buying a particular stock. Add in the potential for that dividend stream to increase as a company performs from year to year, then that sounds like a double benefit.

A reliable, passive income that looks like a permanent stream of cash flowing into your bank account may possibly seem almost to good to be true.

Surely this is the way to build an ultimately successful portfolio?

It is, but as always, the devil is in the details.

Yes, it would be desirable for most of us would-be investors to get an income stream that could make up for a lack of capital growth, or be an addition-to.

But first of all, like most new endeavours, we must do our homework properly to find such companies and consider the ambiguity of such a task. 

What are the stumbling blocks to finding a good looking company paying a good reliable dividend?

Is there more to discover than the eye can see?

What are the unintended consequences of relying on a dividend?

I will sum up first. You have got to be very careful when making such an assumption that a company will in fact pay a dividend.

I suppose the most logical way of approaching the dilemma is to ask yourself, Why should a company pay a regular dividend?

Such a question is exactly what will be discussed at Board level (the company's Board of Directors).

But here's the rub. Most companies pay some sort of dividend because the Board (yes those at the top above management and directing some wisdom and governance) have come to the simple decision (not simple mind you) that it does not need a certain amount of capital in the future to run the company. Repeating, this is not a simple decision, maybe at the best of times, but nevertheless a decision that is on the minds of most company Directors (and top management typical the CFO and CEO who will reason with the Board the merits) when they approve half year and yearly results.

What you can do is to see if there is any consistency to a company paying a dividend and to look at past behaviour.

What has happened in the last five years, for instance. I use the Yahoo Finance database to find information like this. Just bring up a five year chart on such and such a stock and you will see on the graph any dividends that have been paid. Likewise you could use the NZX website to find local information on dividends being paid for any specific stock. Or if you are interested in NZX50 companies, you can use the profiles on interest.co.nz.

Okay, you have eyed up a particular investment prospect from the above initial analysis (everything looks promising, say 5yrs in row it has paid dividends half yearly in succession) but you are still curious. Rightly so, because we've only just started on this research.

Next you should try and work out what percentage of earnings that dividend represents (and if you can, calculate free cashflow; I know it is a bit tricky at this stage of your knowledge vocabulary, but try). The reason you want to look at these metrics is because, as you'll get to understand, profitability never stays still. Change is a constant for any company.

For instance the higher the dividend versus earnings, then the higher the possible likelihood that such a dividend payment in a bad year might not be feasible.

Contrast that situation to a company that pays a low dividend relative to earnings. Here the future payment of a dividend might seem to be more secure.

You can also look at what has gone on in the last five years from both viewpoints, i.e. earnings and dividends. Can you see some correlation? Is there a pattern?

Now you want to hear the story from the horse's mouth. Read the latest company earnings result and identify what is the current declared dividend policy. These inquiries I am throwing at you are good for you, reduces naivety. The more you delve, the more you'll find and you'll be wiser for the exercise.

Most companies will in fact have a dividend policy, so see if you can find this documentation and lock it into your mind and make scribblings about the company you are focused on. I am hoping you are writing things down because this will help you build up your own picture about how you see the company in this particular instance.

A mid-term warning. Shit can happen. I mean, for whatever reason a company can all of a sudden stop paying dividends and you are left with a non-income generating asset. As you can understand this isn't in the plan. But hang in there, this happens to all us portfolio builders.

I point this abrupt possibility out because we have seen it across the board here in NZ in the last 12 to 18 months as companies have had to navigate the uncertainties of Covid-19.

But it is not all doom and gloom in such a scenario. Good companies generally do resume paying dividends after such roadblocks, so have patience and be humble. You aren't the only one feeling the bump in the road.

What you don't want to be caught up in, is a company that pays a high dividend versus earnings and at the same time carries a bucket load of debt. Debt is a killer, so try and fathom if you can from your general readings, especially that latest report, how much debt the company is carrying. There is a lot of work involved in really defining an optimal debt level, but be aware. If a company has less than a year's earnings in debt, then should be all fine, a semi no-brainer. Multiples higher, then I would be more cautious on assumptions going forward.

So don't fall into the trap of thinking that all high dividend paying companies are all strawberries and cream. Actually the best approach maybe to aim for a lower yielding company, one that maybe you think will have the possibility in paying higher dividends of the future.

Yes I am making you think as this is part of the education in analysing what companies to add to your portfolio. Build your awareness, write your thoughts down, especially ones that seem material to you.

So get going, start investing for an income stream. It's got to be good for you.

Tony Morgan has run a portfolio management business and an equity brokerage, both of which were purchased by Craig Investment Partners. He now runs a small family office that invests globally. Other articles in this series can be found here. And the profiles of all the NZX50 companies can be found here.