Understanding Dividend Investment During Market Crash | IFG

In a previous recent article, I mentioned that the current market crash is a good time to get started on investing in the stock market as long as you have a long-term outlook.

In this article, we’ll discuss dividend investing. And how market crashes can be a unique opportunity to get amazing dividends for years to come. Please note that this article is NOT financial advice, nor is it a recommendation. If in doubt, please seek help from a financial adviser.

We’ll be sharing some stocks that I’ll be researching in the coming week. We recently shared that we liked Shell – that was not only giving a 14% yield at the prices it was then, but has also since increased in price by around 40%.

What are dividends?

Dividends are payments made to shareholders out of profits.

Let’s say XYZ plc, in which you invested in 2 years ago, made £30m in profits this year. Their board would get together and decide what to do with that money. They would have a few basic options:

1. Keep the cash in the bank for an uncertain future event or project;
2. Reinvest the money back into the business with the idea that investing £30m back into the business today (by opening a new factory, for example) would add more back to the company in profits;
3. It can distribute this cash out to shareholders; or
4. It can do a mixture of these things, by distributing a certain amount to shareholders and keeping some in the bank.

Option (4) is what nearly all companies who pay dividends do. Some even have a target % that they try to return to shareholders via dividends.

What dividends mean for you?

They mean passive income.

Dividends are the most passive of income sources I know. You buy shares (usually online and super simple) and you literally do nothing. The money drops into your online share account.

Like any form of income from investment, you should be looking at your yield. That means the return on your investment and it’s usually expressed as an annual percentage.

For example, if I buy shares in XYZ plc for £10, and I get 50p back as a dividend, that would be a solid 5% yield.

For context, a decent buy-to-let property yields something like 5-8% (but comes with the hassle of actually having to maintain a property).

So what’s the big deal about market crashes and dividends?

There’s two really important principles which make market crashes and dividends a great combination:

1. Dividends depend on the business itself and how profitable it has been for that year. It is not linked to share price. This means that dividends are relatively stable. They’re not locked in or guaranteed, but companies are very reluctant to cut or cancel dividends as it doesn’t reflect well.
2. The share price of that company on the stock market is just a reflection of what people are willing to pay for a share of that company. It’s a reflection of human psychology and supply/demand. It can therefore throw up anomalies where people are irrationally selling down. Share prices can therefore be variable and volatile.

Now that you’ve understood those two things, think back to the concept of yield that we discussed earlier.

Imagine now if XYZ plc’s share price had tanked during the market crash. Remember we bought 1 share for £10 and got a 50p dividend? Well now, XYZ plc’s share price has tanked to £6 a share.

But you’ve researched XYZ plc, and you’re confident that the underlying business is going to be just fine. Perhaps you’ve also heard an interview with the CEO where he talks about how they were well prepared for this crisis, and that actually business is better than ever.

You hit the button and buy the shares at £6 per share.

Turns out you were right: XYZ plc had a very good year and didn’t suffer too badly from the coronavirus impact. The board declare the same dividend as last year: 50p.

But here comes the best bit. You bought your shares at £6 per share, and so your yield is a fantastic 8.3%.

And nobody can take your shares away from you either. So for the rest of your life, you will be getting these dividends (which hopefully get better each year as well) and you’ll only ever have paid £6 per share for them.

Even better is the fact that as the years go by, if XYZ plc is performing well, it’s likely that its share price is also going to increase. So not only will you be getting income via the dividend, but if you ever decided to sell the shares, you’d be making a profit on them too.

The criteria I look for when dividend hunting

Looking for these companies isn’t as simple as just searching for the companies who pay the most dividends. In fact, that can be quite dangerous as data is always historic. So you will be looking at last year’s dividends but trying to work out whether that company can sustain the same dividend in the current climate.

If the market (i.e. people) has slashed the share price of a company to such an extent that its dividend yield is now something crazy like 30%, then that is a red flag. It suggests that most people believe that the dividend is going to get cut or, worse, cancelled.

I am actively looking for these dividend bargains in the current market.

The first company I always look for in market crashes is Shell. Whilst there are definitely some big concerns for Shell, I take very strong comfort from a few key factors:

• An extremely well-run company with a long tradition and history.
• An extremely strong record of paying dividends (they haven’t cut the dividend since WWII).
• A company adapting to the changes of the modern world by investing in the future (and whilst this means increased spending, the messaging in their reports is always that they think equally about shareholders and the investment case).
• They’ve come through tough times before.

Of course, research should be more detailed than this including looking at financial reports and market commentary for yourself, but the following are the key criteria and questions I’m asking myself when looking at companies right now:

1. The company must be doing well or, at the very least, not be suffering during the coronavirus impact.
2. The coronavirus impact should bring about a fundamental change in society which benefits the company or, at the very least, doesn’t harm it.
3. The company should be a big, blue-chip company and listed on a major index like the FTSE100. This is a natural filter to get rid of any companies which don’t have great track records or which only recently started paying dividends.
4. Dividend coverage ratio of 1.5 or more. Dividend coverage ratio is basically how many times over could the company pay out its dividend. The idea is that if a company could pay it 1.5 times or more, it’s less likely to be a candidate for cutting its dividend as it has healthy cover. You can working it out by looking at total net income divided by total dividend paid out (or earnings per share divided by dividend per share). Note, Shell is actually quite low for this particular metric (1.04) but I’m personally okay with it in the context of the other ratios and the wider picture.
5. Free cash flow to equity ratio. Profit is different to cash flow. If you run a business, you’ll understand this intimately. But for those who don’t, think about the lag you might have as a business between selling something (which you book as profit for accounting purposes) and actually getting paid. You need to know that the company has got sufficient cash to pay the dividend.

If you are interested in more interesting ratios and understanding, I highly recommend bookmarking this detailed read.

Stocks I’m looking at right now

If any of you want to help me research, one I’m about to start researching is Microsoft. I think from a business standpoint, they definitely hit the criteria I’ve mentioned above. Use of their Microsoft Teams has understandably shot up during the pandemic and, as a user of it ourselves with our team here at IFG, I think it is a fantastic product (and we tried a good few including their main competitors). They’re not a big dividend payer but I love to be invested in great companies at great prices.

For the same reason, I may well go for Apple who are sitting on a huge cash pile and could make some great acquisitions in a depressed market.

Here are some other candidates for research based on a really quick screen on. The screen criteria I used were:

• UK company
• Dividend yield of 4-15% (this sifts out the crazy yield companies which are likely just anomalies)
• Market cap of £1bn or more

Sharia compliance & other resources

Please note, I’ve not done my shar’i analysis on any of those companies. Automatic screeners are often not nuanced enough, so we recommend our course to fully understand how to screen shares. It’s not that hard, but it’s detailed and needs understanding.

Another great resource for picking out good dividend candidates is our zero-debt companies list.

How do I get started?

You just need to open a shares account. I personally use AJ Bell and really like them. You can open your stocks and shares ISA using the button below.

NOTE: today 5 April 2020 is the last day of the tax year. You get a maximum of £20,000 allowance to put into an ISA every year to benefit from tax-free gains. This allowance does not roll over. Open an account today to benefit from your allowance this year which will reset to £20,000 tomorrow.