Dividend investing is a proven method to build sustainable wealth.
As an investor, my aim is to accumulate stocks that could deliver increasing dividends over time. I started with little and gradually added onto my portfolio as my income grew. Ten years to today, I have a six-figure portfolio that pays five figures in yearly dividends. Also, I’d accumulated some lessons and experiences arising from both the successes achieved and losses incurred as I was building my portfolio.
So, what if you are starting afresh?
What if you aspire to build a dividend-based portfolio?
If that’s you, read on. In this article, I’ll list down 4 mistakes that you should avoid when investing for dividends in Malaysia. Hopefully, avoiding them can improve your chances of success as you make sounder and wiser decisions. These 4 mistakes are as follows:
Mistake 1 – Chasing High Dividend Yields
Let’s say we have A Bhd and B Bhd.
A Bhd offers a current dividend yield of 4% per annum.
B Bhd offers a current dividend yield of 8% per annum.
There are investors who will invest in B Bhd over A Bhd without further due diligence. To them, it is a no-brainer as RM 10,000 invested in B Bhd could yield RM 400 more than A Bhd as its yield is 4% greater.
This often leads to disappointing results, especially when the business fundamentals of B Bhd is inferior to A Bhd. If B Bhd is a company that fails to sustain its dividend payments, its returns will falter, causing both a fall in subsequent dividend yield and capital losses.
Hence, to avoid this mistake, it is helpful for investors to first determine both the business quality of A Bhd and B Bhd. If A Bhd has better fundamentals than B Bhd, A Bhd at 4% per year can be a way better investment as compared to B Bhd despite its offering at 8% a year.
So, focus on fundamentals first. Don’t chase high dividend yields.
Mistake 2 – Stable DPS despite Falling Profits
The logic for dividend investing is – “The more profits a business earns, the more dividends it will and could pay out to shareholders”.
There are companies that struggle to earn more profits but understand that some investors don’t perform thorough due diligence for as long as the amount of dividends remains steady. Thus, it’s possible for these companies to dig into their cash reserves to maintain dividend payments. This often spells bad news to investors and will lead to similar disappointing results as Mistake 1.
This is a classic example of a dividend trap, which is set up for inexperienced and lazy investors who want recurring dividends but slack on due diligence. Here, I’ll label the trap as “Level 1” as I find that such a trap could be easily avoided, only if one is more diligent in studying the business fundamentals of a company.
Mistake 3 – Stable DPS; Little or Negative Operating Cash Flows
The trap is “Level 2”. It is harder to avoid and has entrapped some seasoned investors. To pull it off, first, these companies would report growing revenue and profits. But, these profits are “mere accounting profits”. They struggle to bring in positive operating cash flows. Or worse, they would incur negative operating cash flows. Despite such, these companies somehow can increase and grow their dividend payments to shareholders.
So, how could they pay out rising dividends despite struggling to bring in operating cash flows?
The answers are: “borrowings and fundraising activities like rights issue and private placements”
These companies tend to raise funds from debt and equity more frequently than they should.
The above situation exists as some companies knew that investors would trace main figures like earnings and dividends, but not operating cash flows. As such, the trick to mitigate this “Level 2” trap is to assess not just a company’s ability to generate profits but also operating cash flows.
Mistake 4 – High Dividend Yield Doesn’t Mean “Undervalued”
Let’s say we have C Bhd and D Bhd. Both companies are fundamentally solid.
C Bhd offers a current dividend yield of 4% per annum.
D Bhd offers a current dividend yield of 5% per annum.
Some investors would invest in D Bhd, viewing it to be “undervalued”. That view is not complete. What if we did a little more calculation and found that:
C Bhd’s long-term dividend yield averages at 3% per annum.
D Bhd’s long-term dividend yield averages at 6% per annum.
In this case, C Bhd at 4% a year is undervalued as it is above its long-term average. Whereas, it is the reverse for D Bhd. At 5% a year, it is overvalued as it is below its long-term average. So, it would be a better deal to invest in C Bhd at 4% a year as compared to D Bhd at 5% a year.
Conclusion:
In brief, investors who can avoid the four mistakes above would have a headstart in investing for recurring and rising dividend income. This could be done if investors would first assess a stock’s business fundamentals and second calculate its valuation. Without them, investors might be at a higher risk of purchasing shares of poor quality stocks (believing and hoping for dividends). That would increase the chances of setbacks, which could cause some to lose confidence in dividend investing.
Here, I have prepared a Free Webinar to discuss:
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