Dividend income investing strategies

Let's take a look at some dividend investing strategies that you might consider and the main pitfalls to avoid.

Don't just buy shares with high dividend yields

It's worth reminding ourselves of what we are trying to achieve. Right at the start of the bonds article (read it here), I set out the income challenge that do-it-yourself investors are facing up to. Most of them are trying to get a better income than is available from handing their money over to an insurance company in return for a guaranteed income for the rest of their life - known as an annuity.

Here are the incomes that a £100,000 savings pot will currently buy a man just about to retire from annuity providers. Remember, anyone going down this route will - unless they buy a special type of annuity - never see their £100,000 again.

• 55 years old - £4,741 or an income percentage of 4.74%
• 60 years old - £5,181 or an income percentage of 5.18%
• 65 years old - £5,852 or an income percentage of 5.85%

So if you are looking to use a share portfolio for income instead of an annuity it might seem that all you have to do is to go out and fill your boots with shares paying a dividend yield (the dividend income per share as a percentage of the share price) of 5-6%.

If you open up ShareScope or SharePad you can find a list of shares meeting this criteria in a matter of seconds as shown below.

In the FTSE 350 index there are currently 30 shares with a forecast dividend yield of 5%. If you were to cast your net wider and look in the FTSE All-Share index you will currently find 51 shares meeting this criteria. Many of the companies are household names. Shouldn't you just go ahead and buy 10-15 of them, sit back and wait for the income to roll in?

Not so fast. Unfortunately life is not as simple as that. If only it was. This is the kind of scattergun approach that could land you in big trouble. There are often four major problems involved with blindly buying high-dividend-yielding shares:

• The dividends aren't safe. They could be reduced or disappear entirely in the future.
• Yields can be temporarily flattered by special or one off dividends and may not be a reliable indicator of income from a share in the future.
• A portfolio has too many shares from the same area of the economy (there are six mining companies in the list above). This can mean that you aren't spreading your risks widely enough.
• The dividends are unlikely to grow much. This could mean that the income from a share portfolio might not keep pace with increases in the cost of living (inflation).

Dividends that don't look very safe

High dividend yields are often a warning sign that the dividend is not very safe and could be cut. One quick and easy way to check the safety of a dividend is to look at the dividend cover ratio. This looks at how many times the dividend per share can be paid out of current or forecast profits. You calculate it by dividing a company's earnings per share (EPS) by its dividend per share (DPS). The higher the dividend cover, the safer the dividend payout is likely to be. If a company's dividend cover is less than one (meaning that the dividend per share is bigger than the earnings per share) then its dividend is said to be uncovered.

For example a company with EPS of 100p, paying a dividend per share of 100p will have a dividend cover of 1.0 times. If you prefer, you can think about dividend cover a different way. If you reverse the calculation (divide DPS by EPS or 1 divided by the dividend cover ratio) you get what is known as the dividend payout ratio. So the company in this example is paying out 100% of its profits in dividends. If profits can't grow in the future or fall then the dividend per share will not grow or will fall.

A safer dividend is one where the company has EPS of 100p and is paying a DPS of 40p. Here the dividend cover is 2.5 times (100/40) or the payout ratio is 40% (40/100 or 1 divided by 2.5). Profits have room to fall before this 40p dividend per share is under threat.

Let's take a look at our table of high yielding shares again.

What you can see is that the dividends of a lot of these very high yielding shares don't look safe at all. The dividend cover ratios are very low or not even covered at all (the dividend cover is less than one). The shares might be expected to pay out a large income during the next year but can they be relied upon to do so in later years?

The chunky dividend payouts expected from the likes of Evraz or Direct Line are essentially double the level of expected EPS and probably unrealistic or one-off payouts. This is telling you to do some digging and find out what's really going on here.

Too many eggs in too few baskets

It's a good idea when you are building a dividend income portfolio to spread your money around. Being reliant on too many shares from one sector of the economy might cause you problems if that sector hits hard times, profits fall and dividends are cut or scrapped.

It makes sense to own at least 10 and preferably 15 shares from different parts of the economy. By doing this you are spreading your sources of income around and this can help you to lower the risk that the income from your share portfolio could fall sharply in tough times.

Looking at our list of high yielding shares it is virtually impossible to spread your money around well. A large number of these shares come from depressed sectors such as mining, oil and gas and financial companies - hardly the basis of a sensible income portfolio.

Dividends that will struggle to grow

Companies with low levels of dividend cover (or high dividend payout ratios) can find it hard to grow their dividends in the future. If profits don't grow then there is little or no room to keep dividends growing. In fact dividends are more likely to fall as even a small fall in profits can make the current dividend unaffordable.

This is what seems to be the case with many of the shares in our list of high yielders. I've used SharePad to calculate the expected growth rate in dividends over the next three years as forecasted by City analysts. It is comparing the forecast dividend in three years' time with the most recent annual dividend per share.

As you can see from the list of the top twenty highest yielders, the expected growth in dividend payments is expected to be quite sluggish. Companies such as BP, SSE and Glaxo are good examples of this. Some dividends are expected to be lower. It seems that whilst you can get a high yield on some shares there is a price to be paid in terms of lower future growth or even a lower dividend income.

Some shares look more interesting at first glance but a little digging around can tell you what's going on. For example, Direct Line's very high forecast yield looks to be based on the expectation of a sizeable, one-off special dividend. Excluding this, its yield would be around 3.5%. That said, it is expected to grow its underlying dividend at a healthy rate going forward. Lancashire holdings, another insurance company, has a high yield and high dividend growth rate. But this is due to the fact that it didn't pay a special dividend in 2014 but is expected to in future years. What you need to try and avoid is buying a share with a high yield due to a special dividend that will only be paid once. When you are looking at dividend yield, always try and work out what the value of it is based on the underlying dividend - the one that is based on a company's current profits.

Also bear in mind that analyst forecasts can often be wrong and too optimistic. To be a good dividend investor, you really need to research the company and satisfy yourself that the dividend is safe and that the outlook for future profits can allow it to grow.

The risk of buying a portfolio of high yielders similar to the ones in the list above is that the income you will get from your portfolio isn't going to grow much and won't be much different from what you might get from an annuity (you do keep hold of your money though). It might therefore be worth considering a different strategy.

Trawling for a dividend portfolio

There are literally endless ways to search for dividend-paying shares, but I am only going to concentrate on a few approaches right now.

As always, the shares in these filters are not share recommendations. You should always thoroughly research a share yourself before investing.

So we started out by casting our net for shares with yields of 5% or more. Now it's time to try something different. Have a look at the filter from SharePad below.

Here I am using four criteria to search for shares:

1. A reasonable forecast yield of at least 4%
2. Forecast dividend cover of at least 1.5 times. This might seem quite low but I don't want to exclude companies with stable profits such as utilities that can be steady and reliable dividend payers.
3. Forecast dividend growth of at least 3%. This again might seem quite low but if combined with a high enough yield a share that meets this criteria might still be suitable for a portfolio.
4. The company must have paid a dividend to its shareholders for at least ten consecutive years. Whilst it is not unheard of for companies with impressive dividend paying histories to suddenly slash their dividend (Tesco springs to mind here) those that have paid them for a long time have shown that they have the ability to withstand the ups and downs of the business world. This may be a sign that they can do so again and that their dividend is safer than others.

As you can see, only 16 shares meet these criteria. However, ideally we need more shares from different sectors of the economy to build a portfolio. It's time to cast the net a little bit differently.

Here I've changed the criteria slightly:

1. The minimum dividend yield has been reduced to 3%.
2. The forecast dividend growth rate has been increased to 5%.
3. The forecast dividend cover is reduced to 1.2 times.
4. An historical dividend growth criteria has been introduced. I am looking for companies that have grown their dividends for at least 9 consecutive years. In other words, where dividends have been growing since at least 2005 or 2006. This means they will have kept growing their dividends through the last recession (2008-09) which could be a sign of a robust investment.

This gives a list of 12 shares to look at as shown below.

But I might want a few more shares to look at. So, I've decided to forget about dividend yield entirely and look for shares that are expected to have strong dividend growth. The criteria I have set are:

1. Minimum dividend cover of 1.5 times.
2. Forecast dividend growth of between 10% and 25%.
3. At least ten years of continuous annual dividend payments.

This gives me a list of 35 shares, with the top 30 shown below.

Income tomorrow rather than income today

Most of this article has been based on the task of producing a reasonable income today from a portfolio of shares. However, you might not be interested in income today but in ten or fifteen years' time when you want to retire. Would you need a different portfolio strategy to meet this objective?

Quite possibly. Instead of focusing on income producing shares you might want to focus on shares with higher growth potential to build up the value of your retirement fund so that you can turn that into more income in the future.

That's not to say that a dividend portfolio can't be a good strategy to build up your savings though. If you invest in a portfolio of high dividend paying shares, you are getting a decent chunk of your total return (the change in share price plus dividend received) from the dividend. Once that dividend has been paid, it cannot be taken away from you. A rising share price can always fall back.

But if you then use your dividend to buy more shares (known as dividend reinvestment) of the company it is possible to build up a sizeable pot of money over a long period of time (I'm talking about more than ten years here). You do this by tapping into probably the greatest wonder of the financial world. I am talking about the concept of compound interest.

With compound interest, you add any interest you receive to your initial savings or principal investment. As interest is paid on the principal, by adding interest to it the amount of interest you can earn goes up (assuming the interest stays the same or doesn't go down too much).

With shares, you use the dividend income to buy more shares which hopefully produces more dividend income to buy more shares and so on. Repeat this process for long enough and you can end up accumulating a lot more shares and a lot more income.

Let's apply this principle to our example dividend portfolio.

Share	Share price	DPS	Shares bought	Yr 1 income	Yr 10 shares	Yr 10 income	% change
GlaxoSmithKline PLC	£14.19	£0.81	423	£342.49	697	£564.46	64.81%
HSBC Holdings PLC	£5.95	£0.33	1,009	£331.99	1,638	£539.04	62.37%
RPS Group PLC	£2.27	£0.10	2,646	£259.32	3,872	£379.50	46.35%
Marston's PLC	£1.53	£0.07	3,932	£275.23	5,887	£412.10	49.73%
Aberdeen Asset Management PLC	£3.59	£0.19	1,674	£317.99	2,664	£506.13	59.17%
Amlin PLC	£5.22	£0.29	1,149	£329.89	1,861	£534.03	61.88%
Stagecoach Group PLC	£3.89	£0.12	1,542	£178.92	2,009	£233.08	30.27%
SSE PLC	£15.28	£0.90	393	£354.58	658	£594.48	67.66%
Imperial Tobacco Group PLC	£33.71	£1.41	178	£250.79	257	£362.54	44.56%
WPP Group PLC	£14.77	£0.44	406	£176.71	528	£229.46	29.85%
National Grid PLC	£8.55	£0.44	702	£308.03	1,101	£483.37	56.92%
Diageo PLC	£18.21	£0.59	329	£195.06	439	£260.14	33.37%
Pearson PLC	£11.98	£0.54	501	£269.95	744	£401.14	48.60%
Pennon Group PLC	£8.20	£0.34	732	£247.32	1,052	£355.74	43.84%
Cobham PLC	£2.63	£0.12	2,286	£262.86	3,362	£386.64	47.09%
Portfolio total				£4,101.12		£6,241.87	52.20%
Year 1 yield on initial cost	4.56%
Year 10 yield on initial cost	6.94%

I am going to make a few assumptions here to keep things fairly simple.

• An investor buys £6,000 each of the fifteen shares to give an initial total investment of £90,000.
• The share prices and dividends paid do not change for ten years (this will not happen in the real world).
• The costs of buying shares (commissions and stamp duty) are ignored.

So a £6,000 investment in GlaxoSmithKline buys 423 shares (rounded up to the nearest whole number). With a dividend per share of £0.81 this gives an income of around £342 in the first year. This is then used to buy another 24 shares. And so on. After ten years, the investor ends up with 697 shares and an annual dividend income of £564 from Glaxo shares - an increase of 64% compared with the income in year 1.

Repeat this process for the whole portfolio and the annual income produced from it increases by 52% from £4101 to £6241. The value of the portfolio has also increased from £90,000 to £134,787.

All this has been achieved by reinvesting dividends with no dividend growth, no increases in share prices and no extra money added to the portfolio. If you can pick a share which delivers strong dividend growth then it is possible to make fabulous gains in wealth particularly over a long period of time. The longer you repeat the process of dividend investment, the better the results can be.

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.