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Beyond yield: three questions every income investor should ask

A reliable dividend requires more than an attractive headline yield. Henderson High Income Trust’s (HHI) fund manager David Smith shares the three key questions he asks when assessing an income opportunity, from cash flow and balance-sheet strength to growth prospects and valuation.

The first article of this series, Why the highest dividend yield isn’t always the best investment, explored why an unusually high dividend yield can sometimes be a warning sign rather than an opportunity. Once we’ve looked beyond the headline yield, the next step is to assess whether the income is sustainable and capable of growing over time given dividend yield and dividend growth combined are the main contributors to total returns over the long term.

When assessing an income opportunity, three key questions can help guide the analysis.

1. Is the dividend sustainable?

The first question is whether the company generates enough cash to support its payments to shareholders.

Reported profits are important, but cash generation often provides a clearer indication of dividend capacity. Factors such as how reliably profits convert into cash, how much of that cash is being paid out and whether the dividend could be maintained through more difficult trading conditions can provide valuable insights.

A company may be able to cover a dividend comfortably when the economy is strong. A more revealing test is how resilient those payments would be if revenues weaken, costs rise or interest payments become more burdensome.

Balance-sheet strength is also important. A heavily indebted business has less flexibility because lenders and other financial commitments must be paid before ordinary shareholders. If cash flow comes under pressure, the dividend may be one of the first areas reviewed by management.

2. Is the company investing enough to grow?

A sustainable dividend depends on a sustainable business.

Companies with resilient business models, strong market positions and opportunities for long-term growth are often better placed to support and increase dividend payments over time.

That makes disciplined capital allocation important. Management must decide how much cash to return to shareholders and how much to reinvest in the business. The best companies strike a balance between rewarding shareholders today and investing for future growth.

Growth only creates value when that investment generates attractive returns. When capital is allocated effectively, investment in the business can support future profits and cash flows, providing a stronger foundation for dividend growth.

This is why income investing should not be confused with investing in companies that prioritise dividends over investment.  We want to own companies that pay an appropriate dividend but balances it with investment in their own business to support future profit, cash flow and dividend growth.

3. Is the valuation attractive?

A good business and a good investment are not always the same thing.

A good company can still produce disappointing returns if investors pay too high a price for it. Equally, a company experiencing a temporary difficulty can become attractive if its valuation more than compensates for the risks.

Valuation therefore has to sit alongside income sustainability and business quality. The key consideration is what expectations are already reflected in the share price and whether the potential reward justifies the uncertainty.

The objective is not simply to own good companies. It is to identify undervalued businesses with the potential to deliver profits, cash flow and dividend growth. That combination of dividend sustainability, dividend growth and valuation forms the basis of HHI’s investment approach.

Answering these three questions can help investors focus on the quality of an income opportunity rather than simply its yield. However, successful income investing is not only about whether a dividend is sustainable today. It is also about whether that income has the potential to grow over time.

The next article in this series looks at stock examples in the portfolio that have consistently delivered dividend growth and what it has meant for investors.

Balance sheet

A financial statement that summarises a company’s assets, liabilities, and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. It is called a balance sheet because of the accounting equation: assets = liabilities + shareholders’ equity.

Cash flow

The net balance of cash that moves in and out of a company. Positive cash flow shows more money is moving in than out, while negative cash flow means more money is moving out than into the company.

Dividend

A variable discretionary payment made by a company to its shareholders.

Share price

The price to purchase (or sell) one share in a company, not including fees or taxes. For investment trusts: The closing mid-market share price at month end.

Valuation metrics

Metrics used to gauge a company’s performance, financial health, and expectations for future earnings, e.g. P/E ratio and ROE.

Yield

The level of income on a security over a set period, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, in its simplest form, this is calculated as the coupon payment divided by the current bond price.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.

 

Before investing in an investment trust referred to in this article, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser. Please refer to the AIFMD Disclosure document and Annual Report of the AIF before making any final investment decisions. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change.

 

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

The information in this article does not qualify as an investment recommendation.

 

There is no guarantee that past trends will continue, or forecasts will be realised.

 

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Glossary

 

 

 

Important information

Please read the following important information regarding funds related to this article.

Before investing in an investment trust referred to in this document, you should satisfy yourself as to its suitability and the risks involved, you may wish to consult a financial adviser. This is a marketing communication. Please refer to the AIFMD Disclosure document and Annual Report of the AIF before making any final investment decisions.
    Specific risks
  • Some of the administrative expenses are taken from capital. This allows more income to be paid but it may also restrict capital growth or even reduce the capital over time.
  • Losses could be incurred if a counterparty became unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
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  • This investment should be held as part of a broader diversified portfolio. Balancing it with investments that have different risk profiles can help reduce the impact of any single investment underperforming.
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