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The Basics of Dividend Investing


Published by Bob Ciura on April 9th, 2017

The secret is out: dividend investing works.

It wasn’t too long ago, that dividends were considered too boring. But the bursting of the tech bubble, and the Great Recession of 2008-2009, changed investor sentiment, perhaps for good.

Dividend stocks were once referred to as “widow and orphan” stocks. Now, investors of all age groups have discovered the appeal of dividend stocks.

Dividends offer income that investors can choose to spend however they want—for example, to help supplement a retirees’ income, or to buy more shares of a company and grow dividend income over time.

Dividend reinvestment in particular is one of the greatest ways to build wealth, because it unleashes the power of compounding interest.

For example, there are the Dividend Achievers, a group of 265 stocks with 10+ years of consecutive dividend increases.

You can see the full Dividend Achievers List here.

To investors just getting started, the concept of dividend investing can be overwhelming.

This article will discuss the basics of dividend investing, the important things to keep in mind when buying dividend stocks, and how to go about getting the process started.

What Are Dividends?

Dividends are a portion of a company’s earnings that are distributed to investors who own the stock. A firm may decide to pay a dividend to shareholders, after all expenses are paid.

Dividends are paid on a per-share basis, and are usually expressed as a percentage, which is called a dividend yield.

The dividend yield is calculated by dividing the annualized dividend payment by the current share price. It shows how much income will be generated from a stock, as a percentage of the initial investment.

For example, McDonald’s (MCD) has an annual dividend of $3.76 per share. The stock closed at $129.96 per share on April 7, meaning its current dividend yield is 2.9%.

If an investor were to buy $10,000 of McDonald’s stock, at the present dividend rate, the stock would generate $290 in dividend income over the next year.

The great thing about dividend stocks like McDonald’s, is that they raise their dividends over time. McDonald’s has increased its dividend each year since it paid its first dividend in 1976.

Increasing dividends over time result in higher levels of income for the investor. Five years from now, the investor who bought McDonald’s would receive roughly $370 per year in dividend income.

And, the result would be even higher, if the investor reinvests the dividends along the way, to purchase additional shares.

Not all stocks pay dividends. Instead, many companies prefer to use excess cash flow to reinvest in the business, make acquisitions, repurchase stock, or pay down debt.

For investors wondering where to look for the best dividend stocks, the lists of Dividend Achievers and Dividend Aristocrats are good places to start.

Companies that have maintained long histories of increasing their dividend payments each year, have demonstrated that they have time-tested business models.

In addition to the Dividend Achievers, investors should look into the Dividend Aristocrats, an even more exclusive group of companies in the S&P 500, that have raised dividends for 25+ years.

You can see the entire list of Dividend Aristocrats here.

Typically, large companies are among the most reliable dividend payers. These are classified as large-cap stocks, which generally have market capitalizations of $10 billion and above.

Small companies tend not to pay dividends, because they are more focused on growth.

That said, there are a number of small-cap stocks that do pay dividends. For example, water utility American States Water (AWR) is a small-cap, with a market capitalization of $1.6 billion, and it has increased its dividend for the past 62 consecutive years.

Dividend yields can vary. Investors can find dividend stocks that yield below 1%, to double-digits in some cases.

High dividend yields are enticing, but investors need to perform proper due diligence before buying, to ensure that the payouts are sustainable.

An extremely high dividend yield of 10% or more can often be a sign of upcoming danger. Such a huge yield indicates that the market doubts the company’s financial position, and whether the dividend will remain intact.

Dividend Payers vs Non-Dividend Payers

Just because a stock pays a dividend does not necessarily mean it is automatically a better investment than a stock that pays no dividend.

Start-up companies, or those generally earlier on in their development, will rarely pay a dividend.

These types of companies need to reinvest as much cash flow as they can back into growth initiatives, to get the business off the ground.

So don’t expect Snap, Inc. (SNAP), which held its initial public offering earlier this year, to ever pay a dividend to shareholders.

That said, there are more bad reasons than good, for not paying dividends at all.

It is understandable why management teams may not love the idea of paying dividends to shareholders.

Dividends urge a company’s management to be more responsible with cash flow.

They help keep a management team ‘honest’, in the sense that after making dividend payments, there is less money left over for empire-building acquisitions, or lavishing executives with generous share-based compensation.

Many companies, particularly in the tech sector, heavily favor share buybacks over dividends. There is nothing inherently wrong with this, provided the companies conduct share repurchases in the proper manner.

Share buybacks can help a company increase its earnings-per-share. When a company uses some of its excess cash flow to repurchase its own shares, there are fewer shares outstanding.

This means that each remaining share, receives a higher portion of a company’s profits. This can help earnings-per-share increase. Think of it like a pie—with fewer slices, each remaining slice is bigger.

However, a company that repurchases shares only to offset the dilutive impact of stock options issued to employees, is doing its shareholders a disservice.

This became an issue in the aftermath of the tech bubble, when investors began demanding dividend payouts from large technology companies with established business models, billions of cash on their balance sheets.

As a result, there are now many tech companies that have started paying dividends. And, since the best-in-class tech companies generate high levels of cash flow with low levels of debt, they can raise their dividends at high rates each year.

One example of this is Texas Instruments (TXN), which raised its dividend by 30%+ last year.

Management may not want to be obligated to the dividend, especially when the economy enters a downturn.

However, there is sufficient statistical evidence that indicates dividend payers have significantly outperformed non-dividend payers over time—with a lower level of risk as well.

Dividend

Source:  Rising Dividends Fund, Oppenheimer

According to the above study, $100 invested in stocks that initiated or grew their dividends consistently in 1972, turned into nearly $6,000 by 2013.

All dividend-paying stocks turned $100 into $4,131 over the same time period.

Stocks that paid no dividends at all turned $100 into just $99—meaning they actually lost money. In the Oppenheimer report, non-dividend payers were by far the worst-performing group, even worse than stocks that had cut or eliminated their dividends during the study period.

As a result, it seems pretty clear that dividend investing is the way to go.

But even within the dividend stock arena, investors need to do their research, to make sure they are buying shares of a company that can sustain its dividend through good times and bad.

Not All Dividend Stocks Are Created Equal

When deciding which dividend stocks to buy, there are many important factors that investors should keep in mind.

Ultimately, a dividend is only as strong as the company that pays it.

Investors should look for companies with strong brands, durable competitive advantages, generate consistent profitability, and have solid growth potential, among other important qualities.

These factors can be summed up with The 8 Rules of Dividend Investing, which systematically ranks dividend stocks.

In order for companies to pay dividends, and raise them over time, the underlying business model must generate profits that exceed the dividend payout.

One of the ways investors can gauge a company’s ability to pay its dividend is the payout ratio.

A payout ratio is calculated by dividing the annual dividend per share, by the company’s annual earnings-per-share.

Like dividend yield, the payout ratio is also expressed in terms of a percentage.

The payout ratio helps determine the sustainability of a company’s dividend, and whether it is in danger of a dividend cut.

A payout ratio that exceeds 100% means the company is paying out more than it is earning.

That is why investors should look for companies with manageable payout ratios. The best dividend growth stocks are often those that strike a good balance between a satisfactory yield, and a payout that has room for future growth.

For example, one of the most tried-and-true Dividend Aristocrats is 3M (MMM).

3M currently has an annualized dividend payment of $4.70.

In 2016, 3M had earnings-per-share of $8.16.

This means 3M’s payout ratio is 57%, based on last year’s profit levels. This is a very healthy payout ratio.

3M distributed slightly more than half of its earnings-per-share from 2016, which leaves plenty of room for further dividend growth.

This is especially true, since 3M is a high-quality company, and its earnings-per-share will likely increase going forward.

It should be no surprise, then, that 3M has increased its dividend for 59 years in a row.

However, that does not mean dividend stocks are risk-free investments.

Potential Pitfalls of Dividend Stocks

A dividend cut or elimination is typically the worst-case scenario for an investor.

Not only does a dividend cut result in less dividend income for the investor, but it is also usually accompanied by a large reduction in the share price.

This is because a dividend cut slashes the dividend yield, and a declining share price pushes the yield back up. Dividend yields and stock prices move in opposite directions.

For example, let’s say a company trades for $50 per share and pays an annualized dividend of $2 per share.

The stock is currently yielding 4%.

If the company cuts its dividend to $1 per share, the dividend yield declines to 2%.

In many cases, the stock in question would see its share price decline as well, to elevate the yield back up.

In order to get back to a 4% dividend yield, the stock would have to decline to $25—which would be a 50% decline.

A dividend cut is a signal that the fundamental position of the company is deteriorating. That is why investors are typically not willing to pay an equal or higher price for a company that just cut its dividend.

It is important to remember that dividends are never guaranteed. They are purely at the discretion of a company’s Board of Directors, and are largely a function of the financial performance of the company.

Stockholders are residual claimants; meaning, equity holders are entitled to all residual profits generated by a company, after all operating expenses and debtholders are paid.

For investors desiring greater certainty of income, it may be appropriate to consider buying bonds or preferred stock, which have a higher position on the financial totem pole.

Interest is paid to bondholders before dividends are paid to stockholders, which makes dividend payments less certain than dividends.

The trade-off is that the rewards for stock ownership, especially over long periods of time, can trounce the returns of bonds or preferred stock.

Why Buy Dividend Stocks?

The most convincing argument for buying dividend stocks is that they have proven to be among the best vehicles to building wealth over long periods of time.

In the past decade, the S&P Dividend Aristocrats outperformed the S&P 500 Index, by more than two percentage points per year.

Aristocrats

Source: Standard & Poor’s

Dividends provide a boost to investors in multiple ways.

Dividend stocks are typically less volatile than non-dividend payers. And, dividend payments can serve as a valuable margin of safety against falling markets.

When share prices go up, dividends can be viewed as a nice kicker, a ‘cherry on top’ of the total returns so to speak.

When markets are declining, dividends help cushion the blow. And, by reinvesting dividends, falling share prices allow the investor to buy additional shares of a company, at lower prices.

Reinvesting dividends helps juice the magic of compounding interest.

Using dividends to purchase more shares of a stock, means investors own more shares after every dividend payout.

These new shares generate their own dividends, which helps purchase even more shares with each passing year.

This creates a ‘snowball effect’ that can produce significant wealth over time.

Consider the case of Altria (MO), one of the most legendary dividend stocks of all time.

Altria is a tobacco giant, which manufactures the Marlboro cigarette brand in the U.S., along with a number of other smokeless tobacco, cigar, and wine businesses.

Altria has increased its dividend 50 times in the past 48 years.

To show the impact of dividends, on April 7, Altria closed at $71.42 per share.

Exactly 30 years prior—on April 7, 1987—Altria closed at an adjusted price of $7.25 per share.

This means, that over the course of that three-decade period, Altria increased in value by nearly 10-fold, thanks largely to all those reinvested dividends.

(It is also worth noting that in that time, Altria spun off several companies that now trade independently, and have paid their own dividends for many years).

In fact, noted economist and Wharton School professor Jeremy Siegel wrote in his well-known investing book The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New that Altria was the best-performing stock from 1925-2003.

Over that time, Altria generated 17% annualized returns.

The ‘secret sauce’ that helped make Altria the best stock to own for nearly 80 years, was that the stock was perpetually undervalued.

Due to the constant fears of regulation and class-action lawsuits, Altria stock historically traded for a low valuation. When investors received their dividends, they reinvested those dividends at low prices.

This is why, while it may sound crazy, investors interested primarily in growing their dividend income over time, should actually root for stock prices to stay low.

That way, dividends can be reinvested at lower prices, which buys more shares than if the share price were higher.

For this reason, dividend growth investors should not be afraid of declining share prices—in fact, they should learn to embrace uncertainty.

When this happens, it accelerates the snowball effect.

How to Buy Dividend Stocks

Suppose an investor has decided they would like to buy dividend stocks. The question now is, how does an investor go about it?

Buying stocks used to be a very time-consuming and costly process.

An investor had to call their broker and instruct them to place an order, which could take hours to complete. And, the investor would have to pay a steep commission for doing so.

Today, things have changed.

Thanks to the rise of online trading, brokerage commissions have come way down—for example, Fidelity Investments recently reduced their trading fee to $4.95, down from $7.95.

Now that we are in an era of do-it-yourself investing, opening a brokerage account and placing trades can be done with a few clicks of a mouse.

There are a number of brokerage houses to choose from. Once an account has been opened and funded, an investor can simply type in a stock symbol, choose how many shares they would like to buy, and place the order.

Two of the most common types of stock orders are market orders, and limit orders.

A market order is essentially buying the stock at its current market price. In most cases, brokerages will guarantee execution of a market order.

A limit order allows an investor to stipulate the maximum price they want to pay for a stock. This gives investors greater control of the exact price they pay for a stock.

But limit orders are not always filled, if the stock does not reach the specified threshold that the investor wants.

Important Dates to Keep in Mind

Once the investor has purchased a few dividends for their brokerage account, they may soon wonder when they will see those dividends start rolling in.

Every company has its own dividend schedule. Some companies pay dividends once per year; others pay them semi-annually, or more commonly, quarterly.

There are even some stocks that pay their dividends each month. One that comes to mind is Realty Income (O), a Real Estate Investment Trust which has trademarked itself as “The Monthly Dividend Company”.

A thorough analysis of Realty Income, in comparison to one of its biggest peers in the REIT space, can be found here.

When looking at dividend stocks, there are a few important dates to keep in mind:

For example, on February 16, Coca-Cola (KO) raised its dividend for the 55th year in a row.

The company’s first quarter dividend was payable April 3, 2017, to shareholders of record as of March 15, 2017, with an ex-dividend date of March 13.

So, what did all these dates mean?

The payable date is fairly self-explanatory; it is the date that investors will receive the dividend. But you must own the stock well before then to qualify for the dividend.

An investor who bought Coca-Cola on April 2, thinking they would receive the dividend, was likely disappointed once April 3 rolled around.

The record date is the date on which the investor needs to be listed on the company’s record books as the owner.

Once the record date is set, the ex-dividend is set, based on stock market exchange rules. In most cases, the ex-dividend date is two business days before the record date, as in the Coca-Cola example.

The ex-dividend date is the most important date to keep in mind, because investors must buy the stock before this date in order to receive the dividend.

An investor who bought Coca-Cola stock on or after March 13, did not receive the dividend. Instead, those selling the stock on or after March 13 received the first-quarter payout.

Final Thoughts

Investing in dividend stocks can seem like a daunting task. But it seems more complicated than reality. And, the rewards of learning the basics of dividend investing are clear.

Dividend stocks are one of the best ways for investors to build wealth.

By focusing on the Dividend Aristocrats and Dividend Achievers, and adhering to The 8 Rules of Dividend Investing, investors can build a portfolio filled with strong dividend growth stocks.


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