If you’re buying a dividend stock, you expect to collect a dividend. However, dividend stocks are not obliged to pay dividends. In fact, they can do whatever they want with the dividend, including maintaining it, raising it, cutting it, and even eliminating it.
Mining companies such as Barrick Gold Corp. (TSX:ABX)(NYSE:ABX) and Goldcorp Inc. (TSX:G)(NYSE:GG) have cut their dividends at least once in the past few years. Investors can’t blame them, though.
Whether they make money or sustain losses is heavily reliant on the underlying commodity prices. If precious metal prices rise, Barrick Gold and Goldcorp benefit. Likewise, if precious metal prices go down, so will the miners’ profitability.
Further, lower earnings and dividend cuts lead to lower share prices. Even with the recent rally, the miners are still under the water by 50% from their 2011-2012 highs.
So, if you care about your dividend income safety, you can focus on company quality, dividend quality, and diversification.
Company quality
You can focus on only buying quality companies. These are companies with strong financial profiles and an investment-grade credit rating of BBB+ or better. The higher the rating, the better.
On top of that, quality companies should also have established competitive advantages that allow them to sustain and grow their profitability.
The Big Five Canadian banks have been known for their long histories of profitable operations. They all have S&P credit ratings between A+ and AA-. Because they operate in an oligopoly environment, they have some pricing power while maintaining their market positions.
Dividend quality
The banks continue to be very profitable, so they continue to pay out strong dividends with payout ratios of about 50%. So, it comes down to buying these banks on dips against the advent of bad news. When prices go lower, dividend yields go higher.
Of the five banks, Bank of Nova Scotia (TSX:BNS)(NYSE:BNS) is the best valued today. At $61.70 per share, it’s priced at about 10.7 times its earnings and yields almost 4.7% with a payout ratio of just under 50%.
If investors can buy these banks when their yields are at the high end of their historical ranges, they can essentially hold them to earn a growing income and ignore any price volatility.
Surprisingly, excluding the financial crisis, buying Bank of Nova Scotia in recent years when it’s reached a 4.3% yield has been a pretty good deal. So, the chance to buy the bank at a yield of above 5% early this year was actually a rare opportunity.
Conclusion
Bank of Nova Scotia is a decent buy today as it’s about 12% discounted from its normal multiple. It also yields a sustainable and growing dividend yield of 4.7%. However, the bank is only one company. By diversifying your portfolio in quality companies with strong dividends across different industries, you can improve your dividend income safety.
For instance, you can limit yourself to earn up to 5% of dividends from any one company and 15% from any one sector to avoid concentration risk. So, if a company cuts its dividend or there’s a sector-wide problem, your portfolio as a whole might still continue generating a higher income for you.
