The FTSE didn’t rewarded investors in 2022, unless the investors in question had very resource-focused portfolios. The reality is that many stocks are down, considerably.
But a correction also creates opportunities, and that’s what I’m looking at today. Specifically, those related to dividends.
Disaster or opportunity?
The FTSE 100 is up slightly over the past 12 months, but that’s largely because the index has been hauled upwards by surging resource stocks — oil and energy giant Shell is up a huge 39% over the year.
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Instead, the FTSE 250 is more reflective of the health of the UK economy and the performance of the wider market. The index has slumped 20% over the 12 months.
Meanwhile, stocks in the housebuilding sector are down around 40% over 12 months, on average. Housing giant Persimmon has had a whopping 55% wiped off the value of its share price.
The thing is, these corrections don’t come around all that often. With sky-high inflation and a recessionary environment, things look pretty bad right now. But I believe the macroeconomic environment and the market will improve throughout the 20s.
Rising yields
So I’m looking at the fallen part of the market. I don’t tend to buy stocks that are on a bull run, so I’m staying away from energy companies right now.
Instead, I’m looking at stocks in banking, financial services, healthcare and retail. These are parts of the market that have suffered over the past year. Housebuilding stocks have suffered too, but I’m looking less at this sector right now.
But the important thing to note is that when share prices fall, dividend yields go up — assuming dividend payments remain constant. And, naturally, it works the other way around too. This is one reason why I tend to stay away from surging stocks.
Buying low and selling high is the aim of the game. But buying cheap dividend stocks also gives me the advantage of ‘locking in’ a higher dividend yield.
After all, the dividend yield I receive is also reflective of the price I pay for the stock, regardless of where the share price goes next.
So buying now provides me with a unique opportunity to ‘lock in’ higher yields for my portfolio before the market recovers.
Sustainable yields
When dividend yields get really big, it’s normally a warning sign. For example, as the Persimmon share price fell earlier this year, the dividend yield almost reached 20%. That’s huge, and it proved unsustainable as the dividend payment was eventually cut.
But there was evidence that the dividend yield was unsustainable even before it reached 20%. Looking at the dividend coverage ratio, we can see that Persimmon only just generated enough cash to pay shareholders last year.
And, with the outlook worsening throughout 2022, that coverage ratio likely dropped below one, meaning the firm didn’t have enough cash to continuing paying it.
However, I also need to do my research and look at other fundamentals too. I want to be buying meaningfully undervalued stocks, not just cheap ones.
And that requires me to look at metrics including the price-to-earnings ratio, or the EV-to-EBITDA ratio. For a more complete picture, I’ll use metrics like the discounted cash flow model.
Collectively, this approach can help me generate more passive income and hopefully deliver index-beating returns.
