Published June 26th, 2016
This is a guest contribution by Ethan Featherly of Admiral Markets. The article does not necessarily reflect the opinion of Sure Dividend.
The world of finance functions through a vocabulary of specialized terms and abbreviations. These signal to the other members of society that trading and investing are complex activities that require years of studying and practicing and that therefore, they should be reserved for a small elite.
Once the code is cracked, and the terms explained, the finance world is exposed in its overarching simplicity. Far from being the intricate labyrinth, it is painted to be, this environment is supported by a foundation of terms. Once these are known, everything becomes much clearer. One of them is “dividend,” and it sits at the core of all the wealth created by investing.
What are Dividend Stocks?
Moving averages, trend indicators, and variating prices can be a distraction from the central point of trading and investing in stock. Each share or stock represents a part of a company. While ownership of stocks is not the same as ownership of the company, even when one holds the majority package, it nevertheless entails that payments be made for simply owning stocks in that particular company.
To put it simply, when a portion of a company’s profit is paid to shareholders, that payment is known as a dividend. The amount paid is decided by the Board of Directors and it is via a value that is given to a single share. The more shares are owned by a person, the more money, or passive income, he or she receives.
Dividend stocks are those stocks that are primarily meant to provide dividends to their holders. Their primary purpose is not to be often traded, but to be held for a longer period. By taking into consideration the annual dividend and the current market price per share, the dividend yield is the indicator that tells the investor how much he is earning or is going to earn through dividends alone.
Taking the commitment a step further, dividend growth stocks are stocks whose payments are reinvested into more dividend stocks. This type of “funds” are set up early on for young people, even children. Long time frames are thus the defining feature of dividend stocks.
Types of Dividends
Following the decisions of the board, a company may choose to hand out different kinds of dividends. Cash dividends are the most common. Here, stocks separate into preferred and common stock. Shareholders of preferred stocks usually receive a set amount of money, while common stockholders receive dividends established by the board.
Instead of cash, companies may distribute property dividends to its shareholders. From solid gold to any other item, anything can be considered property dividends. However, this practice is not so common.
In rare occasions such as major litigation win or the sale of a business, special dividends are handed out to shareholders. As these special payments are considered “return of capital” from the initial investment into stocks, they are mostly tax-free.
Strategies to Increase Earnings Through Dividend Stocks
Living off of regularly received dividends is a dream that most investors, and most people in general, have. To increase earnings through dividends, one must make sure that all the conditions for success are met and that the right investments are made.
Strategy 1: Rolling the Portfolio
The majority of companies pay dividends quarterly, meaning that the usual portfolio would gain four payments per year. Rolling the portfolio means that the investor or fund buys stocks just before the dividends are given out. They make this prediction based on their ex-dividend rates, and can thus incur five payments each year instead of just four.
This strategy requires the investor to perpetually buy and sell dividend stocks each year. For this reason, it adds risk to a type of stocks that are largely considered safe. Despite (or because) of this risk, the return value has the potential to be greater. Essentially, this strategy involves that the one doing it acts more like a trader than a long-term investor. For this reason, he or she will need to follow the proper indicators of the market.
One of the ways in which to identify the trends – or their absence – early on is by using the Alligator Indicator. Unlike usual indicators, it signals even the static periods within the market. These are important for dividend stock investors, as they are more interested in the calm of the market than its short-term movements.
Strategy 2: Purchasing stocks in “mature” companies
With its profit, a company can choose to pay dividends, reinvest and expand or pay off debt and repurchase shares. While investing in promising new companies might provide a greater return value, essentially making millions for pennies, mature companies are a safer bet when it comes to dividends. This is because of “mature” companies such as Coca Cola, due to their long history of market presence and success, usually, choose to pay dividends with their profits.
They do so in order to increase the value of the stocks and in turn increase the value of the company. However, the fact that their payments are regular and sizable is a clear advantage. Even more, this kind of companies may decide to increase the value of single-share payments year after year.
Because of the stability and predictability of the company, the stocks themselves will also increase in value, aside from having a high yield, making their selling highly profitable.
Strategy 3: Turning risk into predictability
Most people don’t have the resources to purchase enough dividend stocks so that they can live off the payments from them. Compounding – when dividends are reinvested into buying more stocks, resulting in greater dividends – can also be a slow, albeit highly safe process.
For that reason, investors may choose to bet on the potential of new companies and highly risky stocks or trades in order to amass the capital needed for investing in dividend stocks. In that way, they engage in risky exchanges, but instead of reusing the earnings for trading again, they invest it in dividend stocks.
Strategy 4: Diversifying the portfolio
A diversified portfolio is a safer portfolio. This is one of the first pieces of advice any investing expert will give, as it is a simple matter of not putting all of the eggs into a single basket. Companies can fail, go bankrupt or stagger behind, resulting in a prolonged period in which they do not pay dividends. Counting on just one company is, therefore, a serious mistake.
Aside from being safer, diversified portfolios are also usually the providers of higher returns. In the United States, taxes on dividend income is not as high as in other countries. The sectors with the highest dividend yield are the financial sector, with a yield of 3.22%, the basic materials sector with 2.51% and the utility sector with 2.47%.
There are certain signs to follow when choosing what to invest in so as to secure a high-paying but safe dividend stock. One of them is to look at the previous dividend payout ratio. If it does not exceed 60% to 70%, it means that the company is still holding onto funds and making investments into itself. As such, along with the immediate reward of dividends, you can expect a long-term growth from the part of the company.
Strategy 5: DRIP shares
Some companies offer DRIPs, or dividend reinvestment plans, allowing its investors to purchase more shares with their dividends automatically. The main selling point of DRIPs is that they are commission-free and come at a discount, ranging from 1 to 10%, from the current price of shares.
Companies issue this kind of shares directly, meaning that they increase their liquidities immediately, without waiting for exchanges. Moreover, DRIPs allow companies to raise new equity capital and reduce the outgoing money that would usually represent cash dividends. Because DRIPs are a long-term investment, they also ignore periods in which the company might underperform, focusing on the wider perspective.
While most stocks are bought and sold on the market freely and with a frenzy that is hard to define, dividend stocks are usually held for an extended period. This prolonged time frame is a double-edged sword, as it passes over short-term variations in price but it leaves the investor vulnerable to failures from the part of the company. One example would be Nokia. Once the undisputed leader of its market, now it has almost completely vanished off the stage that it previously dominated.
Dividend stocks can be an island of certainty in an industry that deals in relative values. For this reason, they are highly popular and sought after. Moreover, holding dividend stocks is the closest one can get to living off of passive income. Handled correctly, a portfolio rich in this type of stocks is the primary condition of reaching that status.