Building an ISA with a chunky dividend yield isn’t as straightforward as it may seem. Finding dividend-paying companies with high payouts is easy enough. But determining which ones will actually maintain and grow shareholder rewards is where things get a bit more complicated.
With that in mind, let’s explore five useful tactics to improve the quality and success of a portfolio.
1. Focus on cash flow, not yield
While achieving a high dividend yield portfolio may be the goal, this metric is often irrelevant in the short term. In fact, looking at a stock’s payout level often leads investors astray, missing out on lucrative long-term opportunities.
Instead, focus should be placed on a company’s ability to generate free cash flow to equity (FCFE). This is the money left over after a company has covered its operating expenses, capital expenditures, and obligations to debt holders. In other words, it’s the money generated from operations that’s available for management to pay out as dividends.
The more FCFE a company generates, the more sustainable shareholder payouts will be.
2. Look at the long-term potential
Building a list of highly-cash-generative enterprises is an excellent first step. But in many cases, other investors have also spotted these opportunities, pushing the share price up and the yield down to a range usually around 2-5%.
That certainly doesn’t seem helpful for those looking to reap a 6% or more annual payout. However, just because a yield is low today doesn’t mean it will stay that way. By analysing the strategy and business model, investors can estimate how likely a firm will be able to grow its cash flows in the future.
As FCFE grows over time, dividends are likely to follow, pushing the yield on an original cost basis up. A perfect example of this would be Safestore. Ten years ago, the self-storage enterprise offered a fairly modest yield. But thanks to continuous annual dividend hikes, the yield for those who held on for a decade is now reaping a yield greater than 50%!
3. Diversify sensibly
Finding the next Safestore is obviously easier said than done. However, even if an investor has successfully identified such an opportunity, there remains the risk of disruption.
Even the best businesses in the world have to overcome a constant stream of challenges and threats. And just because a group has seen success in the past doesn’t mean this will be replicated in the future. The pandemic serves as a perfect example of how an external threat can destabilise even the biggest companies in the world.
Fortunately, this risk can be largely mitigated through diversification. By owning a range of top-notch companies operating in unique industries, the impact of one firm cutting payouts is offset by the continued success of others. Having said that, investors should approach diversification with discipline.
It may be tempting to become diversified on day one. However, this could be a crucial mistake. Finding terrific dividend opportunities takes time. And all too often, investors rushing to become diversified end up buying shares in mediocre businesses just for the sake of being diversified.
Instead, I’ve found it far wiser to gradually diversify a portfolio over time if and when a new high-quality income opportunity presents itself.
