A bit of gloating, then some good reads from around the web.

Very nice news reached the velvet-lined inner city bunker that is Monevator HQ this week – we have been nominated for a second time as the ‘Best International Personal Finance blog’ in the Plutus Awards!

Now into their third-year, the Plutus Awards are becoming established as the benchmark for personal finance blogging. Given the vast plethora of blogs out there, it’s very pleasing to make the shortlist in the International category.

Now I know what you’re thinking – Monevator has run the odd article on overseas investing, but it’s not really a blog about international personal finance, is it? We’re many things, but a go-to resource for globetrotting playboys and It girls we’re not. (More’s the pity!)

But in the context of the Plutus Awards, international basically means ‘not American’. This is the country that runs a ‘World Series of Baseball’ that’s populated entirely with U.S. teams, remember.

I’m only teasing, of course – I’d do exactly the same thing if I launched blog awards from here in the UK. Plus, I’m not sure how kindly the judges will look on ironic British asides… 😉

Anyway, other contenders in our category include the up-and-coming UK bloggers at Sterling Effort, Yorkshire-based Miss Thrifty, sometime Monevator visitor Frugal Zeitgeist, and a new blogger to me, Kylie Ofiu.

Naturally, I wish all the contenders the best of luck.

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Whether your aim is to maximise current income or grow your capital, buying shares that pay dividends can be a good match for individual investors who want to directly hold a portfolio of shares, but who don’t want to succumb to excessive trading and speculative activity.

Though it’s been nice to see the increased interest in dividend shares over the past few years, there remains a lot of misunderstanding about dividends, the proper way to manage a dividend portfolio, and how to separate good dividend shares from bad ones.

In the next few months, my aim is to start from the ground up, to help create a lasting source of dividend education for and with the Monevator community.

What are dividends?

To understand what dividends are, first we must review what a share represents to an investor.

When you buy a share of a company, you’re literally doing just that – buying a share of the company itself – and by doing so you become part-owner of that business. You may not have much say in the company’s day-to-day operations, but you nevertheless get to share in the company’s profits and normally receive the right to vote on corporate policy.

As a company grows and matures, it typically becomes more profitable (otherwise it probably wouldn’t have lasted that long) and produces more cash flow. Concurrently, however, the maturing company frequently finds that it has fewer suitable investments in which to reinvest all the extra cash it’s generating.

When this happens, companies often decide to return some of the extra cash to shareholders in the form of dividends rather than hoard it or reinvest it in value-destroying projects. And because you own a fractional share of the company, you are entitled to receive your proportional amount of the dividend paid to shareholders.

We’ll discuss dividend policy in more detail in a future part of this series, but for now the important thing to remember is that dividends are cash paid by companies to shareholders.

This may seem elementary, but it is an absolutely critical concept to remember when evaluating dividend-paying shares: unless the company generates more than enough cash to sustainably fund the dividend, the dividend is more likely to be cut or suspended.

From time to time we hear about companies cutting their dividends, and there’s always a group of investors that didn’t see it coming. In future articles, I will introduce ways to notice a risky dividend by paying attention to cash flows and a company’s financial health.

What dividends are not

One common misconception about dividends is that they’re paid out of a company’s profits.

It’s easy to see why some investors may think that’s the case as the ‘dividend cover’ ratio – earnings/dividends – is the primary dividend health metric found in financial data sites and analyst reports.

The problem is that earnings are an accountant’s opinion and do not 100% translate into tangible cash. A company with aggressive accounting policies, for example, can artificially boost reported earnings for a time whilst generating less actual cash flow. This can make the company’s dividend look healthier than it really is.

As investor curiosity about dividends has increased, so has the misconception that income generated from dividends is a perfect substitute for the low interest rates currently being offered by fixed income products.

But dividends from shares are not a straight replacement for fixed income.

• A bond is a contractual lending agreement between you and a company in which you lend a set amount to the company and in return the company will repay you interest at an agreed-upon rate and schedule, and at maturity the company will pay you back the amount you originally lent it.

• With shares on the other hand, there is no maturity date, no contractual obligation to pay interest or return capital, and in the event of bankruptcy ordinary shareholders usually get nothing while creditors tend to get some of their capital back.

Dividends are not guaranteed. If the company runs into hard times and isn’t generating enough cash, it can cut or suspend its dividend. As such, investors keen on moving money from low-interest bonds to higher-yielding shares should be fully aware of the differences between shares and bonds.

Make no mistake – dividend-paying shares, properly vetted and assembled in a portfolio, can be an excellent tool for generating income. The key thing to remember is to not allocate funds to shares for higher yields alone.

Be sure that the funds you’re reallocating to shares will not be needed in the short-term and that you’re comfortable bearing the risks inherent to shares.

Until next time

We’ve covered some basics here, but I think it’s important to start from the beginning and build a good foundation of knowledge. In the next article I’ll continue with this bottom-up approach by explaining what we mean by dividend yield.

Until then, please post your comments, questions, and thoughts below!

You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.

The law of unintended consequences follows regulation like seagulls chasing trawlers, and so far one of the most negative side-effects of the Retail Distribution Review (RDR) has been to sting the pockets of those who can least afford it – small investors.

Monevator readers have registered their complaints loud and clear, as new platform fees, custody charges, and fund dealing costs have weighed down returns that are hardly blazing as it is.

But your pain hasn’t gone unnoticed.

Discount broker Interactive Investor (iii) has contacted Monevator to say it would like to hear your ideas about how it can improve its service.

You’ll remember that iii’s RDR cost hikes caused quite a furore recently.

Previously, iii had been one of the most passive investor friendly platforms in the UK. One price rise later and many Monevator readers were heading for the exits.

If it’s broken, fix it

So how do you think discount brokers should serve investors in a post-RDR world – where platforms can no longer rely on fund providers to pay them commission from a fund’s TER?

Even if you’ve never used iii, you probably have an opinion about online brokers. What would your dream broker be like?

Most here will have experienced frustration, confusion, or poor customer service at the hands of an investment platform. Information is often harder to extract than North Sea oil, responsibilities are opaque, and many brokers are like debt – easy to get into but hard to get out of.

There may also have been times when you agonized over an investment decision, and wished your broker offered easy-to-use tools that made life easier.

It would be easy to say: ‘I want all my services for free. In fact, no, as I’m so special, you must pay me to join you and guarantee my investment returns and send me chocolate hearts whenever I’m slightly down in the dumps.’

But well, that would be too good to be true, and no-one (sane) begrudges a business’ right to turn a profit.

My own broker wishlist is pretty extensive, but I’ll kick off the discussion with a few thoughts:

• Charge small investors a percentage fee to hold their funds rather than a flat rate.

• If that’s too costly then provide small investors with preferential rates on ISA accounts only – encouraging investing in the first place will surely benefit brokers over the longer term.

• Sell discounted bundles of trades that an investor can buy upfront and then use over the course of a year.

• Offer an X-Ray scanner that analyses and compares funds in a portfolio.

Those are a few of my ideas, but we’d love to hear yours. This is a unique opportunity to make yourself heard by an interested party who can improve our investment lot. Maybe together we can conjure up the best online broker that’s practical in the real world.

Rant if you need to – by all means tell ’em where they’re going wrong – but then let’s have your ideas for where they could be going right.

Take it steady,

The Accumulator

Note: There is no commercial angle to this post for Monevator. Interactive Investor approached us because it wants to hear the ideas of our investment community. If this helps iii and anyone else who is listening to improve services for small investors and to understand our views, then that’s all to the good.