There is more to dividend investing than simply picking stocks with the highest yields. A dividend strategy that focuses only on yield does not necessarily translate into greater returns, because stocks with higher yields do not always outperform lower yielding ones.
All too often, income-hungry investors give in to the temptation of a high yield, only to see the dividend get cut and the share price collapse. Instead, investors should focus on companies with sustainable dividend outlooks and growing free cash flow generation.
With this in mind, I'm going to take a look at whether investors should buy these 3 dividend stocks:
HSBC's(LSE: HSBA) 7.8% dividend yield clearly stands out from the crowd. Its yield is the highest of all large UK bank stocks and well above the FTSE 100 Index's average dividend yield of 4.0%.
In line with its progressive dividend policy, HSBC raised its dividend to $0.51 per share in 2015, and is set to raise it further, to $0.52 per share for 2016. But although dividend payouts have been rising, earnings have been on a steady downtrend. As a result, dividend cover has been steadily falling too, and currently stands at just 1.3 times.
What's more, asset sales, particularly the disposal of its Brazilian unit, are seen as vital to securing HSBC's progressive dividend policy. HSBC still needs extra capital before it meets the stricter capital rules that are set to come into force in 2019, and the only way to meet those stricter requirements without cutting dividends is through asset sales.
However, big M&A deals are risky, and if a sale falls through or becomes delayed, HSBC may have no option but to cut dividends. And that's before we factor in the risk of further bad loans in Asia or a further softening of economic growth in emerging markets.
The markets clearly agree that HSBC is at risk of a dividend cut. Shares in the bank have fallen by 15% since the start of the year, and dividend futures are pricing a 22% cut in its dividend for 2017.
After strong dividend growth over the last decade, Diageo(LSE: DGE) seems set for a future with slower growth. A downturn in emerging markets and changing consumer tastes have weighed on the performance of the world's biggest distiller. Organic sales rose by just 1.8% in the 6 months to 31 December, while adjusted EPS slumped by 4%.
The distiller is combating the slowdown in sales by expanding into new markets, such as Turkey and India, and cutting costs. All these efforts require money, and with earnings in poor shape, there is little room for further expansion in dividend payments.
Diageo raised its interim dividend by 5% this year, but that's down from a rise of 9% last year. And despite the slower pace of dividend growth, dividend cover is falling too. Only three years ago, earnings covered its dividend payments by more than 2 times. By the end of 2016, its dividend cover is expected to fall to just 1.5 times.
That still means its dividend is secure, but with a yield of 3.1%, you would expect to have more growth potential.
Earlier this week, small-cap rival Stock Spirits Group(LSE: STCK) announced a 10p per share special dividend to be paid to shareholders on 27 July 2016. The record date for the special dividend is 8 July 2016, meaning potential investors need buy the stock two days before that date to be entitled for dividend payment, under the T+2 standard settlement period.
The company is able to pay this special dividend because the board is no longer seeking major M&A deals. Under pressure from activist investor Luis Amaral, management is trying to unlock value by returning more cash to shareholders.
Including its special dividend, I expect Stock Spirits to pay around 15p in dividends this year. This gives it a very attractive prospective yield of 9.3%.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Diageo and HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.