I think dividend investing should be a key part of any investor’s toolkit. Just buy a share with a high income and gradually, year after year, your returns snowball. What’s more, high-yield investments tend also to be value investments. So pick your shares well and you can have a high and rising dividend yield, as well as an increasing share price. It seems the ideal way to accumulate wealth.
But how do you choose these dividend investments? A lot of people pick the companies with the highest dividend yield. After all, these shares should be the cheapest. They are value investments and contrarian investments.
Contrarian opportunity, or danger ahead?
Sometimes, there is no clear reason why the company is so cheap, and so it may present a contrarian opportunity. But, sometimes, a very high dividend yield can be a sign of danger ahead. Often a company with an unusually high dividend yield is cheap for a reason. The company may be in trouble, or in decline.
My experiences with RSA Insurance Group (LSE: RSA) were a case in point. In 2011, at the time of the Eurozone crisis, insurers such as RSA and Aviva were beaten down and looked very cheap. They were out-of-favour and looked like buys.
In particular, RSA was on a P/E ratio of just 10, with a dividend yield of 8/9%. It had the highest yield of any FTSE 100 company. So I bought in. And then I waited.
But there was no dramatic rebound. Earnings in 2012 were lower than in 2011, and the share price was clearly trading within a range. I was collecting the dividend yield each year, which was very welcome, but the share price wasn’t budging.
Look at the trend of RSA’s share price and you see a gradual downward trend from 2007 onwards. I concluded that this was not a company that would quickly turn around. Instead, this was a company in long-term decline. So early in 2013 I sold.
Prospects and sustainability are key
Later that year RSA was hit by a crisis in Ireland, with an overstatement of profits which led to an emergency £775m cash call, and earnings per share of 38p in 2012 turning to a loss per share of 43p in 2013. The share price tumbled. This year’s final dividend has been scrapped.
The trick with investments such as these is, if the strategy falls through, you can at least come out of the investment with a profit rather than a loss.
By buying at the bottom of the trading range and selling at the top, I still made a 30% profit (including dividends). That was enough for me, and it was time to find the next investment opportunity.
And what lessons have I learnt? Well, you need to careful with very high yielders such as RSA. When you see a dividend yield as high as RSA’s, you need to check the fundamentals and, crucially, the prospects of this business. Is the dividend sustainable? Or is this a company which is in trouble? If you’re not happy with what you find, it may be better to invest in a company with a lower, but more sustainable, dividend.
