Here’s why they should focus on dividend stability, rather than size.

Investors love dividends, and with the interim reporting season concluding income-seeking investors will be on the hunt for potential buys.

But creating an income stream through dividends involves more than just picking the highest yielding shares. Morningstar director of equity research Mathew Hodge explains how to help weather-proof your dividend investing strategy for the long term.

We identify some ASX names worth considering below.

Reporting season: dividend highs and lows

It was a mixed bag across sectors, with some companies rewarding investors with solid increases, while others preserved cash ahead of an expected economic slowdown.

This season's dividend upside was felt in the energy sector where sky-high commodity prices brought revenue windfalls for oil and gas giants like Woodside (WDS), which increased its final fully-franked dividend by 37%. Santos (STO) shares rallied after more than doubling its profit and upping its final dividend by 78%.

However, uncertainty over the outlook resulted in a slump in mining dividends. BHP cut its interim dividend by 40% and Fortescue Metals (FMG) sliced 11 cents off its interim dividend to 75 cents.

Dividend favourite Harvey Norman (HVN) also dropped its dividend to 13 cents a share, down from 20 cents a share last year, while supermarket competitors Coles (COL) and Woolworths (WOW) both increased their shareholder distributions on better-than-expected half-year reports.

For income-seeking investors, however, the stability of dividends, rather than the size, should be a key focus, according to Hodge.

He highlights three potential risk considerations to help assess if a company’s underlying income stream is likely to continue flowing through to investors in the long term.

Read about how to build a dividend portfolio.

1. Operating leverage

Hodge says a company’s ability to operate at an advantage to its peers places it in a defensible position likely to benefit a dividend’s stability when times get tougher.

“If you've got a high-cost producer with lower margins than their peers in essentially the same business and demand falls, they're more likely to have their margins and profit cut disproportionately relative to the rest of the industry,” Hodge says.

2. Financial Leverage

Paying close attention to a company’s financial leverage can also provide insight to its long-term dividend potential, Hodge says.

Debt levels are a key factor in assessing a company’s ability to keep delivering dividends over the long term.

“If the music was to pause, that [debt] is now a source of pressure and can force a company to cut back if they don’t have the cash flows for support,” he says.

3. Capital intensity

Looking at a sector’s capital intensity levels can reveal its exposure to knock-on effects to the bottom line and resulting flow through to investors, he adds.

Capital intense businesses require a greater level of expenditure to generate desirable returns.

“Some businesses are very capital light, and whatever they earn, can be distributed,” Hodge says.

“Something like insurance broking can be very light on capital versus something like infrastructure, which is very capital intensive, even though the underlying cash flows are steady.”

Referencing the elevated energy sector dividends this reporting season, Hodge says in the capital-intensive oil and gas sector, the expenditure burden is not noticeable while commodity prices are so high but can become much more relevant as prices fall.

The bottom line - diversification is key

Investors should be cautious when seeking dividends, Hodge says, and remain focused on keeping their portfolios diversified and their eyes on the longer-term.

“Ultimately, it's where a company is going to be in two- or three-years’ time and its longer-term maintainable level of earnings that’s going to drive the majority of the returns and decide whether that investment was worth it or not,” he says.

“If you’ve got banks and REITs and, say, mortgage insurance making up the majority of your portfolio, well it’s all leveraged to real estate. Alternatively, if it’s all energy and oil, all when a recession comes that can go away very quickly,“ he says.

“You can inadvertently build risk in your portfolio by not thinking about what those drivers are. You want to have diversification not just by sector but also by risk.”

4 wide-moat ASX stocks delivering dividends

InvoCare (IVC)

Shares in Australia’s largest funerals and crematoria operator fell more than 10% this week after the company revealed a $1.8 million net loss in its full-year report.