Dividend shares can be a great source of passive income, but investors need to think carefully about which ones to buy. Mistakes in this area can be expensive.
Over the long term, the best results come from buying shares in quality businesses at attractive prices. But not every company fits the bill in this regard.
National Grid
A lot of income investors love National Grid (LSE:NG) shares and it’s easy to see why. The company’s basically a monopoly in an important industry and this is unlikely to change.
Surprisingly, this doesn’t make it a good investment though. Protection from competitors comes at the cost of regulation and this amounts to a significant potential threat.
Over in the US, billionaire investor Warren Buffett has highlighted the risk of regulators preventing utilities companies from earning a good return. And UK investors would be unwise to ignore this.
This actually means National Grid could find its profits limited by forces beyond its control. That’s not something I look for in a stock to buy, so I’m leaving this one to others.
Legal & General
Legal & General (LSE:LGEN) shares have an eye-catching dividend yield of 8.7%. But investors should think about why it’s so high – and why the stock’s down 15% since 2019.
One reason is the business is fundamentally risky. Life insurance contracts are long and pricing them involves trying to assess risks that could be decades in the future.
If things go wrong, the magnitude of the losses can be huge. And it isn’t clear to me that Legal & General has a clear competitive advantage when it comes to pricing policies.
The company has a good record when it comes to dividends and it could certainly turn out well. But I can see a lot of danger that comes with reaching for that big 8.7% yield.
Vodafone
There’s actually quite a lot to like about Vodafone (LSE:VOD) shares at the moment. The stock’s down 48% over the last five years, but there are signs the future could be brighter.
The company’s biggest problem has been the industry it operates in. Excessive competition in a capital-intensive business has resulted in poor returns for shareholders.
Vodafone has a plan to turn things around though. This involves merging with Three in the UK to generate meaningful scale and maximise existing markets where it has no advantage.
This could turn out to be a very good strategy. But nothing’s guaranteed and while some might be attracted to a risky turnaround, I prefer less speculative investments.
Dividend investing
At the end of Indiana Jones and the Last Crusade, the hero tries to identify the Holy Grail from a series of cups. But there’s a catch – the true Grail gives life, a false one takes it away.
It’s the same with dividend stocks. The good ones can provide passive income for decades, but bad ones can prove to be expensive mistakes.
That’s not a reason to avoid buying dividend stocks entirely. But it’s a reason to be selective in working out which ones are worth investing in.
This post was originally published on Motley Fool
