My answer is no.
In the past, my answer was a yes. At that time, when presented with 2 stocks: A Ltd and B Ltd, I would pick the one that offers a greater dividend yield despite it having poorer fundamentals. Simply put, if A Ltd is a strong company that offers 3% in dividend yields and B Ltd is a weaker company, but offers a commendable 6% in dividend yields, I would invest in A Ltd.
Inevitably, I was punked and lost money.
In this write-up, I would like to expound on ‘investment process’ which refers to our steps taken to select the stocks that we want to invest in and to compute or calculate the valuations of these stocks. Here, let us limit our discussions to two different processes that are currently used by dividend investors, and their pros and cons. This is so that you could review and choose between the two of them when building your own dividend portfolio.
With that, let’s have two different dividend investors: Mr. A and Mr. B.
Process 1: How Mr. A Chooses his Dividend Stocks?
Mr. A uses screeners and financial media to find high dividend-yielding stocks in Malaysia and Singapore. Within a few clicks, Mr. A has a list of 20-30 stocks that are offering above 5% in current dividend yields per year. Then, he continues by checking out their past track record of dividend payments. If the stock has been paying rising dividends, Mr. A would keep them in his watch list.
By now, Mr. A is down to his final 5-10 stocks in his watch list from a universe of 10,000+ stocks worldwide. Of which, he dismissed the 3-4 stocks, which are not so affordable and hence, elevating the other 2-5 stocks into his grand finale. His ultimate decision would be to diversify and buy into these dividend stocks, if he feels that their prices are just ‘right’.
So in essence, Mr. A’s investment process is summarized as follows:
1. Use screeners & financial media to find high dividend-yielding stocks.
2. Check their track records of dividend payments to ensure their quality.
3. Discard the ones that are highly-priced as they are not affordable.
4. Buy the ones that are affordable and if their prices are right.
Process 2: How Mr. B Chooses his Dividend Stocks?
Before investing, Mr. B would put any stock into his simple 4 step-process and it is as follows:
1. Study its Business Model and its operational statistics.
2. Assess its Financial Results – make sure it has consistent growth in earnings.
3. Find out its latest Growth Initiatives.
4. Calculate its Valuation Ratios – P/E Ratio, P/B Ratio and Dividend Yields.
So, Are You Investing Like Mr. A or Mr. B?
Well basically, there are pros and cons for both investment processes.
For Mr. A, he could obtain a list of dividend stocks much faster than Mr. B. So, in Mr. A’s case, he has some speed because his way is convenient. However, here’s the question, ‘Does it translate to higher returns at lower risks in the long run?’
Well, not necessarily.
This is because Mr. A’s process may fail to filter out stocks that pay higher yields but have poorer business fundamentals. Presently, there are some stocks which delivered a consistent fall in sales and earnings, struggled to grow, but yet could somehow maintain or even increase dividend payments to shareholders. So, for Mr. A, he would have a greater tendency to buy into these stocks and hence, he is more prone to the risk of value traps.
As for Mr. B, his process includes a detailed study of a stock’s annual reports, its quarterly reports, and corporate announcements. It would definitely be lengthy as it involves a lot of frog kissing to find the one that turns into a princess. Yeap, along the way, Mr. B would meet lots of poisonous toads. But, they would serve as experiences for him to spot and avoid them altogether.
That is why Mr. B is less prone to value traps. After all, he has seen some ‘toads’ in the stock market.
How Not to Use Screeners and Financial Media?
Here, let me reiterate this point.
I’m not discrediting the use of screeners and financial media to select stocks. As I write, these resources can be helpful in narrowing your search, from 10,000++ stocks down to 30-50 stocks.
To me, that is about it.
This is because screeners can’t tell you a lot about a stock’s business models, its story on its financial results, its management style, and its growth initiatives. As an investor, it is up to us to understand these in order to avoid ‘value traps’ that could cause unnecessary investment losses.
A stock’s growth in dividend payments must be backed by its growth in revenue and earnings and positive operating cash flows consistently.
Otherwise, it would be ‘fishy’ to find a stock that could pay out rising dividends, but don’t have consistent growth in sales and earnings and have operating cash flows over the long-term. Highly likely, that stock is a toad.
All in all, stocks that offer high dividend yields do not always end up as winners.
As investors, it is best to use a framework that consists of an understanding of a stock’s business model, an assessment of its financial results, a finding on latest growth initiatives and proper stock valuation. Although it is lengthier, the whole process can help investors to avoid toads and find princesses more efficiently.
Here, if you wish to learn more on the art of stock investing, here’s a free training you can attend: