Income investing is the cornerstone of many peoples portfolios. Buy into a company with areliable dividend yield, and you can accumulate and reinvest those dividend cheques. Its the ideal way to grow your wealth.
But which companies should you buy into? Wellmany investors think that you shouldlook tomining and oil companies such as Rio Tinto (LSE: RIO) and Royal Dutch Shell (LSE: RDSB). After all, these are firms with a track record of cash-generation, with juicy dividend yields.
Are the numbers deceptive?
Check the numbers and they certainlyseem tempting. Rio Tintos current yield is 7.95%. Shells yield is 8.12%. Wow, you say. Even if the share price stays where it is, the dividends alone will provide a very healthy return.
But lets dig a little deeper. What about earnings? Well, this is where things start to fall down. Because the backdrop of tumbling metal, mineral and oil prices means that profitability for both of these companies is sliding.
The P/E ratio for Rio Tinto is 23.58. Shell actually made a loss last year. In 2016 its predicted to have a P/E of 32.72. That looks expensive. The commodities boom of the past decade has meant massive investment in new mines and oil wells. This has led to oversupply, so the prices of iron ore and Brent crude have been trending downwards. Cue falling earnings.
So if earnings are falling, why on earth is the trailing dividend yield so high? Thats becausethis representsprofits from previous years. So they always tend to lag the share price. The share price falls, but dividends are still high so the yield rockets. But this is a temporary phenomenon. These numbers are really just a snapshot.
I expect dividends in the future to be cut, and cut substantially, because profits over the next few years simply wont cover the payouts at their current level.
Dividend investors should look elsewhere
There are other concerns too. A picture of falling profitability means that the share price is also likely to fall. Not only will you receive less income, the value of the shares you own also falls. So you lose in both ways. Suddenly, these companies dont look so appealing.
What investors should look for isnt the highest yield they can find. They should seek out consistency, both in terms of dividend payouts and company profitability. If these are rising steadily each year, then you should buy-in.
The only light at the end of the tunnel is if mineral and oil prices were to recover dramatically, and soon. It could happen, but my balanced view is that commodity prices will remain low for the next decade. This doesnt bode well for income investors who want to buy into resources.
So my advice on Rio Tinto and Royal Dutch Shell remains unchanged. These companies are to be avoided.
If you’re interested in dividend share opportunities, then our experts at the Fool have unearthed a little known firm that’s worth a much closer look. It’s good value, high-yielding, and a growing business.
Prabhat Sakya has no position in any shares mentioned. The Motley Fool UK has recommended Rio Tinto and Royal Dutch Shell B. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.