Investors are routinely drilled on the risks of extrapolating too much from the past when trying to predict the future performance of a stock – but when it comes to dividends, the past can be a useful guide. Indeed, when dealing with dividends, there are actually very few options when it comes to forecasting what will happen next.
On one hand, income seekers can track dividend yields – or the ratio of current payouts to current share prices – as a measure of what their cash will buy them. They can then try and protect themselves by looking at metrics like dividend cover, what analysts are forecasting and even use demanding accounting tests like the Piotroski F-Score to try and judge the security of that dividend. Dividend yield strategies such as the well known Dogs of the Dow (or Dividend Dogs of the FTSE 100) screens require annual re-assessments to weed out the stragglers and disappointments. But it can still be a costly strategy, both from the point of view of those annual trading costs and the risks of dividend cuts that can occur very suddenly when you are focused purely on yield.
Searching For Dividend Reliability
While the past and the present come with risks attached, one of the advantages of analysing dividends is the behavioural bias that tends to influence management when rewarding shareholders. In other words, companies think very carefully before implementing and then increasing dividends, not least because they fear the repercussions of making a cut further down the line – and that is an advantage to investors in search of dividend longevity, reliability and growth.
In a 1985 paper entitled A Survey of Management Views on Dividend Policy, US academics Baker, Farrelly and Edelman found that management were ‘highly concerned with dividend continuity’ and seemed to believe that dividend policy affects share value. The findings tallied with a seminal 1950s paper by Lintner in which a behavioural model was presented whereby managers typically ‘smoothed’ dividend increases over time and only made upward changes when they were sure earnings could support the increase.
As a result of this and a steady stream of academic and market evidence, long term dividend growth has earned a reputation as a yardstick for dividend reliability. In his 1994 book Beating the Street, ex-Fidelity fund manager and investing…
