J Sainsbury (LSE: SBRY) shares an attractive feature with many London-listed companies. It has a high dividend yield. And that quality is one of the main drivers prompting investors to consider stocks for their income portfolios.
It’s a good starting point. After all, a bird in the hand is worth two in the bush, as the saying goes. And that relates to shares because dividend income now can be better than capital gains or bigger income later. Especially if those things fail to arrive as expected.
Compounding dividend gains
Therefore, many investors have abandoned the idea of pursuing capital gains from rising share prices. Instead, they focus on dividend income and either take it immediately, or roll it back into their portfolios to help drive the process of compounding gains.
And the strategy can be very effective and hard to beat. But only if care is taken about which stocks to include in a diversified portfolio of dividend-paying stocks.
In one example, infamous one-time Invesco fund manager Neil Woodford ran a dividend-focused strategy back when he was outperforming. He used to focus on two simple indicators to pick investments. The first was the level of the dividend yield. And the second was the potential for the dividend to grow each year.
But it’s easy to accidentally pick a stock with a high dividend yield only to see that yield remain static. And in the worst dividend-led investments, the dividend goes on to shrink, or disappear altogether.
And one of the trickiest areas of the market involves picking high-yielders among companies operating in cyclical sectors. Those critters often have dividends that are here today and gone tomorrow. But the trouble is they look so tempting with juicy dividend yields at various points in the business cycle.
However, it’s not a good idea to be holding any stock that cuts its dividend. When that happens, the share price often goes lower as well. And that means investors tend to suffer a double hit to the value of their portfolios from shrinking income and plunging capital values.
Weak profit margins
But apart from cyclicals, other weaker businesses may be inappropriate. And, sadly, J Sainsbury may be one of them.
The thing that bothers me about the supermarket sector is that profit margins are so low. And that’s mainly because the sector has always been over-supplied and competitive.
Meanwhile, I’m mindful of how the older supermarket chains found themselves in trouble a few years back. And particularly how deep in the mire Tesco became because it had overstretched its operational reach.
My own solution is to avoid stocks in the supermarket sector altogether. Or at least, if I am tempted, to insist on a keen valuation with an immediate dividend yield at least higher than 5%.
But with Sainsbury’s share price near 270p, the yield for the current trading year is only about 4.8%.
However, the first-quarter trading statement released on 4 July showcased strong business momentum and improving figures. And the company said stronger sales growth was driven primarily by a return to volume growth and lower pricing.
It’s possible J Sainsbury could deliver satisfactory dividend returns for investors over the coming years. But, for the time being, I’m watching from the side-lines because I think I’m seeing better dividend opportunities elsewhere.
