A Beginners Guide to Buying Dividend-Paying Shares

It is common wisdom that a stable, sensible investment portfolio should have a heavy weighting towards income stocks. That is, companies that pay dividends. Relying on strong capital growth is a risky business but if shares pay out steady dividends you can’t go too wrong. That is backed up by recent research in the form of the Barclays Equity Guilt Study. It demonstrated that £100 invested in 1899 across a basket of shares chosen to reflect the changing composition of the London Stock Exchange, 119 years ago, would be worth £204 today when adjusted for inflation.

That’s less than 1% a year ahead of inflation in returns over almost 120 years. Not great. However, when dividends being reinvested is factored in, that £204 becomes £34,758. That’s almost 300% a year average return. While that figure doesn’t factor out inflation, it still clearly represents a strong return on investment.  

So, the moral of the story is that compounding returns by reinvesting dividends is key, right? The logical extension would then be that the sensible investor chooses to invest in the companies that offer the highest dividends. However, that can be a dangerous trap to fall into. The companies offering the highest headline dividends don’t always offer the best returns. In fact, it can be a warning that the company is no longer growing. Markets don’t like companies that are no longer developing and their share price is in danger of falling under those circumstances. This could lead to high dividends but low to zero total returns from the investment.

A good example of a headline dividend luring investors in to a falling share is Centrica. The energy utility once known as British Gas pays a dividend of 8.3%. However, the company’s share price has plunged 63% over the past five years. Within that context, a whopping dividend is of little use to compensating the overall capital loss investors dazzled by it will have sustained over the past half-decade.

A better tactic is to pursue companies offering middling but sustainable dividends or rising dividends. These companies are likely to be investing in growth and over the long term stand a better chance of delivering superior total returns than the highest dividend payers. 26 of the FTSE 100 companies have increased their dividends year-on-year for more than a decade. That’s key to their quality as it demonstrates that they are striking the balance between investing in growth and returning capital to investors.

So the key to successful income investing is, don’t be too greedy for dividends. Look for companies likely to start paying dividends soon, have just started paying them and are growing strongly or have a history of consistent incremental dividend growth over a sustained period of time. There are exceptions to the rule but huge headline dividends are offered for a reason. The company is not growing and needs to resort to dividends to encourage investors in.