By Melda Mergen, Director of U.S. Equities
In a world of low growth and low interest rates, investing for income has never been more challenging. For many investors, the goal is not only to generate a sufficient stream of income, but also to grow their assets to maintain future purchasing power. We believe a disciplined dividend strategy that focuses on rising dividends from companies with growing free cash flow is a vital component to accomplishing this goal, and it should be a core part of any investor's asset allocation.
4 keys to dividend investing
- Dividend growth. When investing for dividends, it is prudent to consider a disciplined strategy that focuses on dividend growth rather than yield alone. A high-yield strategy does not necessarily translate into a reliable stream of income. The best opportunity for success in a dividend strategy resides with the stocks of companies that can sustain and grow their dividend over time. Importantly, returns from these stocks have come with less variability.
- Sustainable free cash flow. The companies need cash, not only to pay dividends, but also to grow the business. If a corporation generates cash returns that exceed what it needs to grow the asset base (i.e., the company is left with free cash flow), then it will have the firepower for dividend growth and other shareholder-friendly actions. Dividends that are not supported by free cash flow may not be sustainable.
- Payout ratio. Investors often look to the payout ratio based on a company's earnings, but we believe this is misleading because earnings are based on accrual accounting, which can be manipulated. To assess a company's true potential to grow dividends and avoid dividend cuts, we prefer to focus on the percentage of annual operating free cash flow consumed by the dividend.
- Active management. Assessing a company's ability to raise its dividend is critical. A history of paying dividends doesn't necessarily mean a company can increase, or even maintain, the dividend in the future. For example, many banks had a long history of paying, and even growing, dividends prior to the great financial crisis. However, excess leverage forced most of them to cut or eliminate dividends. Active management supported by fundamental sector research can help identify and avoid such situations.
The bottom line
When building an income portfolio, investors must balance the need for income with the need to grow assets to maintain purchasing power over time. Fundamentally, we believe that dividend growth matters a lot more than current yield, and following a disciplined strategy based on the four tenets above should produce the best results.
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The views expressed are as of the date given, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.
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