Dividend investing is one great way to build an additional stream of passive income to supplement one’s lifestyle. If you are an income investor looking to receive a consistent stream of dividends, you want to be able identify companies that don’t just pay stable dividends, but also have the potential to increase them every year. Over the long term, this can help you achieve a double-digit yield!
So how do you pick the best dividend-growth stocks for your portfolio? Here are five steps to help you pick the best dividend-growth stocks — using Sheng Siong Group as an example to illustrate the steps.
Step 1: Business must be stable and resilient
If you invest in a company for steady dividends, you want its business model to remain resilient in the long run — even during recessions.
Since its listing on the Singapore Exchange in August 2011, Sheng Siong Group has grown to become one of Singapore’s largest retail supermarket chains with 63 stores located all across the island. The Sheng Siong brand has since become an established household name in Singapore, providing shoppers an affordable wide range of groceries ranging from live, fresh and chilled produce, seafood, meat, fruits and vegetables as well as general merchandise, toiletries, and essential household products.
During a recession, shoppers choose to shop at Sheng Siong because of its low prices and wide selection. When COVID-19 hit Singapore and lockdowns ensued, shoppers rushed to Sheng Siong to stock up on food and essential items.
In the age of e-commerce, Sheng Siong also provides online shopping and delivery for customers. At the same time, co-founder Lim Hock Leng believes that brick and mortar supermarkets are here to stay as they remain part of local lifestyles in a densely populated city like Singapore.
Pandemic or not, consumers like you and me still require our daily and monthly groceries, essentials, and household products. Thus, Sheng Siong fulfills the first step of a stable and sustainable business.
Step 2: Revenue and net profit must be predictable and growing
For a company to pay investors a steady and growing dividend, it must be able to generate predictable and growing revenue and profits year after year. Since its listing in 2011, Sheng Siong’s revenue and profit has been on a steady uptrend; a testament to its stable and growing business.
On the other hand, you want to avoid companies in cyclical industries that earn uneven revenue and profit. A bad year could mean a drop or suspension in dividend.
For example, the oil and gas industry operates through cycles of shifting supply and demand, with these cycles resulting in swings in profit and losses. Early this year, McKinsey reported that the oil and gas industry is experiencing its third price collapse in 12 years — not great for investors looking for stability and a steady dividend.
Step 3: Free cash flow must be healthy
Dividends are paid with cold, hard cash (except for scrip dividends). So besides stable revenue and profits, a company must also be able to generate healthy amounts of free cash flow every year.
Free cash flow represents the cash available in the company after expenditure on physical assets such as property, plants, technology, or equipment (CAPEX) and business operating expenses.
Sheng Siong has been able to maintain healthy levels of free cash flow therefore providing the company the ability to maintain consistent dividend payments to its shareholders every year.
Sheng Siong’s free cash flow was only negative in 2016 due mainly to additions to property, plant and equipment amounting to S$89.9 million. Despite this, Sheng Siong maintained its dividend that year, paying shareholders a dividend per share of 3.75 cents in 2016.
Remember that free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures. Therefore, you also want to avoid companies that require high levels of capital investment to support and maintain their business operations.
The airlines industry is an example of such a capital-intensive business. Despite the economic significance of the airlines industry (all of us require air travel for work, leisure, etc.), billions of dollars — mostly funded by debt — is spent on growing and maintaining the fleet of aircraft. To support air travel operations, airlines incur high fixed and variable costs, primarily for aircraft maintenance, labour, and fuel.
Airlines that expand during an economic upcycle often experience difficulties covering their overheads and servicing their debt in economic downturns. The recent plight of Singapore Airlines and airlines around the world illustrates this case well enough.
Step 4: Track record of paying stable dividends
Sheng Siong has a track record of paying a stable dividend per share that has grown from 1.77 cents in 2011 to 6.5 cents in 2020.
Besides a track record of paying a stable dividend, a company’s dividend payout ratio should also be consistent and mostly stay below 100%. A payout ratio above 100% means that a company is paying more in dividends than it earns in profits, which is unsustainable in the long run.
In the case of Sheng Siong, it maintained a ratio of 90% from 2011 to 2016, and 70% thereafter.
Sheng Siong reduced its dividend payout ratio from 90% to 70% in 2017 in order to conserve its cash reserves. In Sheng Siong’s latest response to shareholder questions, the management has said that the company will continue with its practice of paying 70% of its net profit as dividends.
They explained that they prefer to have a ‘war chest on hand’ and to conserve cash, rather than borrow when the need arises. This practice reflects Sheng Siong’s prudent approach to capital management, to set aside cash reserves that it can use for future expansion and operations, and not rely on debt financing.
Despite reducing its dividend payout ratio to 70% in 2017, the company has still managed to maintain and subsequently grow its dividend per share.
Step 5: Dividend yield must beat the risk-free rate
If you invest in a stock for dividends, its yield should be higher than the risk-free rate you can obtain in the market. Otherwise, you’re better off investing earning the risk-free rate… since it’s risk free.
In the U.S., the risk-free rate would be the interest rate of the three-month U.S. treasury bill. In Singapore, placing your money in your CPF Special Account will give you a risk-free rate of 4% (with the caveat that you can only withdraw a proportion of your CPF funds at age 55). Therefore, it only makes sense to invest in a dividend stock that can give you a yield of 4% or more.
Based on Sheng Siong’s share price of S$1.56 (as at 12 July 2021) and its 2020 dividend per share of 6.5 cents, this works out to a dividend yield of 4.1% — slighter higher than the CPF Special Account interest rate.
Keep in mind that although investors are not taxed on their dividends from Singapore-listed stocks, this may not be true for foreign stocks. For example, foreign investors in U.S. stocks are subject to a 30% withholding tax on dividends. Therefore, a U.S. stock that yields 5% will only yield 3.5% after tax which makes it a lot less attractive.
The fifth perspective
Dividend investing is a proven method of generating a stable and growing stream of passive income. Use the five steps above to screen for high-quality dividend-growth stocks which you can add to your portfolio after doing your due diligence. For an investor who uses a disciplined and systematic approach, dividend investing can help get you closer to your passive income goals. All the best!