How to boost your income as dividends come back in fashion

Dividends are back in fashion. But how do you go about building an income-generating portfolio?

Dividend investing fell out of fashion during the growth stock boom of recent years. It’s not too much of an exaggeration to say that investors didn’t want to hear about companies who couldn’t think of anything better to do with their money than to give it back to shareholders. With interest rates at ultra-low levels and inflation near zero, investors wanted to see growth rather than cash returns.

But that’s changed since inflation became a major worry. Suddenly the idea of receiving a regular and sometimes even inflation-beating payout from the stocks you own has become much more appealing. So if you’re looking to boost the income portion of your portfolio, what should you be looking out for?

Digging for dividends

The good news is that there’s no shortage of appealing-looking dividends out there. The likes of both mining giant Rio Tinto and housebuilder Persimmon offer double-digit yields right now while many other stocks have payouts in the high single-digits.

The bad news is that there’s more to dividend investing than looking down a list of the highest-yielding stocks in the FTSE 100 and picking the top ten. A high yield is often a warning sign – markets don’t like to hand out free money, and if a yield is much higher than the market average, it often signifies scepticism about a company’s ability to pay it. So make sure that the level of dividend cover (see below) is reasonable compared to the sector average.

On that score, perhaps the most important point of all is to diversify. Make sure that your dividend-paying stocks are selected from a range of different industries. For example, chances are that if one housebuilder has to cut its dividends, its peers will come under similar pressures. So don’t look to get all your income from one source.

If you’d rather have someone else build your income portfolio for you, one sensible option is to look at investment trusts. In the year to March, trusts paid out £5.5bn in dividends according to fund administrator, Link. That’s the highest amount since Link started tracking the data in 2010.

Just be aware that much of this came from trusts investing in “alternative assets” and that equity income trusts are expected to grow their payouts more slowly than corporate dividends this year, as they “rebuild” reserves that were depleted by maintaining dividends during the pandemic. Law Debenture (LSE: LWDB) is one equity income trust which we hold in the MoneyWeek model portfolio. It currently yields about 3.7%.

For more on picking dividend stocks, see my colleague Rupert Hargreaves’ article online How to find the best stocks with dividends

What is dividend cover?

Companies pay dividends to shareholders out of their profits. A dividend is entirely discretionary – unlike the interest payment on a bond, it doesn’t have to be paid and it can be cut or even scrapped altogether if deemed necessary. Directors decide what proportion of profits they will distribute: the amount varies depending on how well the company has done (ie, on how much the directors feel it can afford to pay out), but also on other, less tangible factors.

For example, directors tend not to be keen on cutting dividends because the market reaction is typically bad. Also, fast-growing firms tend to pay out a lower percentage of their profits than more mature firms, because they prefer to invest all or most of their profits in opportunities for future growth.

If a company’s dividend yield (the dividend per share expressed as a percentage of the share price) looks particularly high, then that can be a warning sign. For example, if a company is paying a dividend of 10p a share, and the share-price is £1, that’s a yield of 10%. If the average for the index is much lower than that, then it suggests investors are highly sceptical that the dividend will end up being paid.

So when assessing the financial health of a company, it’s worth looking at dividend cover as a guide of how likely it is that the dividend will remain stable or rise in the future. Dividend cover simply measures how many times over the dividend payout is covered by the profits available to pay for it.

To take a very simple example: a firm that makes £20m in profit and allocates £2m for dividends has a cover of ten, while a firm that makes £50m but pays out £25m in dividends has a cover of two. The higher the dividend cover is, the more sustainable the payout. The “payout ratio” is simply the inverse of the dividend cover ratio – so in this example, the first company has a payout ratio of 10%, while the second is on 50%.

SEE ALSO:
Five dividend stocks to beat inflation
The ten highest dividend yields in the FTSE 100
The ten highest dividend yields in the FTSE 250
The ten highest dividend yields on Aim
The ten investment trusts with the highest dividend yields

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