With the stock market taking its time to recover from the 2022 correction, plenty of income stocks are still offering tasty dividend yields.
In fact, looking at just the FTSE 100, there are currently 16 UK shares offering yields in excess of 6%. And the list contains some well-known enterprises such as Vodafone (10.6%), British American Tobacco (8.9%), and BT Group (6.2%).
With the latest government budget reducing the annual dividend allowance, ISAs are becoming even more powerful tax-avoidance tools for investors to leverage. But as strange as it sounds, investing in high-yield stocks may not be the most prudent way to build a high-yield portfolio. In fact, it could backfire quite spectacularly.
So let’s explore the challenges and potential solutions in building a passive income portfolio.
Dividend yield vs reliability
It’s easy to forget, but there are actually two ways for a yield to reach high levels. The first is by the underlying company to increase shareholder payouts. Providing that the management team isn’t using external financing to fund this, it’s usually an excellent sign for investors.
The second is from the valuation suffering a sudden decline. The dividend yield is ultimately a function of the share price. So when a company’s market-cap jumps off a cliff, the yield goes up.
Sadly, in most cases, this second scenario is responsible for high dividend yields. And such share price movements are usually triggered by serious looming issues that could likely compromise cash flow and, in turn, dividends. In other words, reliability goes out the window. And that’s why a large payout level is often a red flag.
Therefore, investors must carefully investigate what is in store for a prospective company’s cash flow. Are customers cancelling orders due to reputational concerns? Or are sales merely being delayed due to temporary short-term disruptions in the supply chain?
There are countless possible reasons behind a drop in valuation. However, if the issues are ultimately irrelevant in the long run, then a jump in dividend yield could be an opportunity to buy some top-notch income shares at a discount.
Expanding horizons
Careful examination of high dividend yields often reveals significant problems. And even some of the largest companies on the London Stock Exchange can make for poor investments. Fortunately, there’s an alternative and one that might be more lucrative in the long run.
Instead of focusing on the stocks that offer a high payout today, investors can explore businesses capable of increasing their dividends in the future. In fact, this is the exact strategy billionaire investor Warren Buffett highlighted in his latest annual shareholder letter.
When he first invested in Coca-Cola in 1988, the dividend yield was only around 4.5%. Today, after 30 years of dividend hikes, his yield has grown to a whopping 54%!
Successfully identifying companies capable of consistently increasing shareholder payouts each year without compromising financial health is far easier said than done. But if I were looking to build a high-yield Stocks and Shares ISA, this is the strategy I would pursue.
