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With growth stocks in the gutter, dividend stocks are rising in popularity. After all, regular compounding payments in a brokerage account brings a strong sense of stability — something the stock market hasn’t been offering lately.
However, while Dividend Aristocrats have a track record of reliability, they’re not necessarily the best income investments.
The hidden truth of Aristocrats
For many income investors, finding and investing in the companies with long track records of raising dividends is the ultimate strategy. After all, where better to invest than in the businesses that have systematically expanded shareholder payouts for decades?
But over time, this dedication can create issues. Instead of investing in new projects and expanding cash flows, management teams can be engrossed in continuing a dividend hike streak, even if it’s unsustainable.
That’s why many such companies only increase dividends by tiny amounts each year. However, the continually rising outflow of capital paired with limited earnings growth causes the payout ratio to rise. And in some instances, firms take on debt just to continue the streak.
Inspecting Britain’s darling
One of the oldest and beloved dividend-paying companies in the UK is National Grid (LSE:NG.). Around 80% of the shares outstanding are held by institutions, mainly in the form of mutual or pension funds. Considering it has raised its dividend for more than a quarter of a century, such popularity makes sense.
National Grid operates its own regulated monopoly, maintaining the country’s electrical grid. Since every household needs electricity, there’s always demand for its services. However, the energy sector isn’t a capital-light one. And the group has racked up massive debts along the way.
Vast amounts of cash flow are increasingly gobbled up by interest payments. As such, earnings have only expanded by an average of 1.7% for the last five years on a per-share basis. Meanwhile, dividends have grown by 3.8% per year over the same period, revealing an expanding payout ratio that already sits at 75%.
In my experience, when a stock’s payout ratio trends up to such high levels, it can be an early warning sign of trouble brewing. This is even more concerning today now that interest rate hikes makes National Grid’s £42bn pile of loan obligations a significant problem. Fun fact: between March 2022 and 2023, the group’s interest expense surged 37.5% despite management paying off £2.5bn from its outstanding loans!
The bottom line
National Grid isn’t the only Dividend Aristocrat with a debt problem. But even if these firms can overcome this challenge, they may still deliver lacklustre returns in the long run. In many cases, the average dividend growth rate is similar to that of National Grid’s – low single digits, barely scraping past inflation.
Of course, there are always exceptions, with some Aristocrats delivering even double-digit income growth to shareholders. But investors aren’t just limited to these companies. There’s a whole world of income-generating opportunities ripe for capitalisation for those willing to spend time digging a bit deeper.
In fact, dividend stocks that aren’t ruled by fear of losing their streak could prove to be far superior investments. Why? Because it means management can remain focused on putting capital in the best place, whether that’s in the pocket of shareholders or in new projects that could propel long-term wealth creation for the business and investors alike.
