Published on January 8th, 2015
Investing in a stock means you have bought a small piece of ownership of that business. Dividend stocks differ from normal stocks in that they pay you for owning them. When a company elects to pay dividends, they are giving a portion of company profits to the owners.
Stocks that reward their owners with actual cash payments (in the form of dividends) have outperformed stocks that do not pay dividends. From January 31st 1972 through December of 2012, dividend stocks averaged 8.8% a year returns. Non-dividend paying stocks averaged 1.6% a year returns.
Source: Ned Davis Research & Chase Investment Insights, page 4
The complete guide to dividend stocks will explain why dividend stocks make excellent investments, how to find dividend stocks, and what perils to avoid. This guide is for you if you are looking to upgrade your investing strategy through dividend stocks.
Don’t let anyone tell you dividends don’t matter. They are wrong. As mentioned above, dividend stocks have returned 8.8% a year on average versus 1.6% a year for non dividend paying stocks over a 40 year period. This is not a fluke. About 42% of total returns have come from dividends alone since the 1920’s. The fact that dividends have accounted for about 42% of total returns since the 1920’s shows just how important a factor dividends are in your investing plan.
Source: Ned Davis Research, Business Insider
Dividend stocks and dividend investing are important considerations for any investment plan. We know that:
- Dividend stocks historically outperform non-dividend paying stocks
- Dividends in general account for a sizable portion of investor returns
By focusing on dividend stocks, you are giving yourself the greatest chance to compound your wealth through investing. Ignoring the evidence of outperformance of dividend stocks is a costly mistake that individual investors should avoid.
Dividend Stock Investing Philosophy
The underlying philosophy of dividend stock investing is that a stock’s value is the sum of its discounted future dividend payments. This makes intuitive sense. The value of any asset is the total of its expected future cash flows, discounted back to present value with an appropriate discount rate. There is no reason stocks should be any different.
Dividend stock investors aim to focus on what they can control; investing in stocks that reliably pay dividends. Stock prices are volatile; dividend payments much less so. By focusing on the income you receive from your investments rather than the price of stocks, you can minimize the anxiety that comes with falling stock prices.
Dividend stocks are like fruit trees. As they grow through time, they produce more fruit (dividends). You can either plant the fruit to grow more trees (reinvest dividends into other dividend stocks) or eat the fruit to live on (use dividend income to cover living expenses). Sticking with the tree metaphor, the following Warren Buffett quote discusses the importance of long-term thinking in investing:
“Someone is sitting in the shade today because someone planted a tree a long time ago”
– Warren Buffett
Understanding Terminology: Dividend Yield & Payout Ratio
The dividend yield is simply the annualized dividend payment divided by the current share price. If a stock paid $3 a year in dividends and had a stock price of $100 it would have a dividend yield of 3.00%:
Here’s the math: $3 / $100 = 3.00%
The dividend yield tells you how much return on your investment from dividends you can expect to make. The highest yielding stock in the S&P 500 is Transocean (Ticker: RIG) with a dividend yield of 18.40%. The lowest yielding stock in the S&P 500 (that pays a dividend) is Cigna Corporation (Ticker: CIG) with a dividend yield of just 0.04%. The current median dividend yield in the S&P 500 is around 2%. A range of 0% to 5% is around the ‘normal’ range for dividend paying stocks. If a stock has a much higher yield than 5%, it is likely a high-risk situation (stock price falls due to risk, driving up the dividend). Dividend stocks with extremely high dividend yields are likely at risk of cutting their dividend payments.
The payout ratio is the percentage of earnings (also called profits, net income, or ‘the bottom line’) the company is paying to shareholders in the form of dividends. If a company has earnings per share of $10 and pays $4 a share in dividends, the company has a payout ratio of 40%.
Here’s the math: $4 / $10 = 40%
The higher the payout ratio, the less profit a company has to reinvest in growth, and the more likely it is the company will have to reduce its dividend payments. If a company has a payout ratio over 100%, it is paying out more in dividends than it makes in earnings. This is clearly unsustainable.
Alternatively, if a company has a very low payout ratio, then it could likely safely raise the payout ratio and give investors a higher dividend yield without sacrificing much growth. The optimal payout ratio depends on a company’s investment options. A cigarette company with limited investment opportunities should have a high payout ratio, while a company that can reinvest its earnings into highly profitable expansion opportunities should have a lower payout ratio.
More Terminology: Total Return & Compound Annual Growth Rate
Any investor (and dividend stock investors in particular) needs to understand total return. Total return is simply the return an investor receives from both capital gains and dividends. Total return is the one ratio that truly matters for investors. The total return formula can be broken down as:
Total Return = Change in P/E Ratio x Change in EPS + Dividends
This formula breaks capital gains into its two aspects; valuation multiple changes and underlying business growth. When the P/E ratio (or other valuation metrics such as PEG, P/B, EV/EBITDA, EBIT/EV, P/S, etc.) increases while earnings remain constant, the stock price will rise. Alternatively, if the P/E ratio remains constant and earnings per share increases, the stock price will also rise. P/E ratios change with investor sentiment, while earnings per share (or EPS for short) change due to underlying business growth (or contraction). Dividends provide stability to investment returns. Capital appreciation returns are much more volatile as they rely on the changing attitudes and perceptions of the investing public.
The compound annual growth rate is the average total return of an investment taking into account compounding. Compounding matters. Here’s an example: Say you have a stock that goes up 50% in value, and then goes down 50% in value. It sounds like you broke even… That isn’t the case. Say the stock price is $10. The 50% gain means it goes up to $15. The 50% loss brings it back down to $7.50. Despite having a 0% average return, you ended up down 25%. The compound annual growth rate takes the effects of compounding into account by finding the geometric (or time-series) average return. The formula to find the compound annual growth rate is below:
((Price now + All Dividends) / Start Price) ^ (1 / # Years) – 1
Where To Find Dividend Stocks
The S&P 500 is comprised of 500 well known US corporations (502 including the 2 share classes of both Google and Discovery Communications). Of these 500 stocks, 425 pay dividends. It is easy to find dividend stocks. Many household name stocks pay dividends, including:
- Coca-Cola (Ticker: KO) – Read Coca-Cola analysis
- Wal-Mart (Ticker: WMT) – Read Wal-Mart analysis
- ExxonMobil (Ticker: XOM) – Read ExxonMobil analysis
- Disney (Ticker: DIS) – Read Disney analysis
- Nike (Ticker: NKE) – Read Nike analysis
An excellent resource to look for dividend stocks is Finviz. You can use the site’s free screener to narrow down your search for dividend stocks. Here is a screen for dividend stocks with dividend yields above 3% and payout ratios under 60% in the S&P 500 Index.
In addition to free screeners like Finviz, indexes made up of high quality dividend stocks are an excellent place to get investment ideas. The Dividend Aristocrats Index, Dividend Achievers Index, and Dividend Kings list are all examined below.
The Dividend Achievers Index is an excellent place to look for high quality dividend stocks . The Dividend Achievers Index is comprised of over 230 businesses with 10 or more years of consecutive dividend increases. You can find the complete list of Dividend Achievers in an excel sheet here (free download).
There are many high quality businesses included in the Dividend Achievers Index that don’t make the cut in the Dividend Aristocrats Index. Some examples include:
If you are not looking for just any dividend stocks, and instead want to find the best of the best, then look no further than the Dividend Aristocrats Index. The Dividend Aristocrats Index is comprised of 54 businesses that have increased their dividend payments for 25 or more consecutive years.
A business must have a strong and durable competitive advantage to raise its dividend payments each year for 25 or more consecutive years. Not surprisingly, the Dividend Aristocrats Index has dominated the S&P 500’s return over the last 10 years. The Dividend Aristocrats Index has a compound annual growth rate of 10.55% a year, versus 7.67% a year for the S&P 500 over the same time period. Outperforming the market by over 2.5% a year is exceptionally rare in the investment world. Investing in high quality businesses that reward shareholders with increasing dividend payments has worked well.
You can find my Top 7 Favorite Dividend Aristocrats here. The linked article also includes additional links (all free) to detailed analysis of each of the 54 Dividend Aristocrats. Individual investors looking for high quality businesses with rising dividend payments should strongly consider looking into the Dividend Aristocrats.
The Dividend Kings list is the most exclusive. It is comprised of the only 16 businesses that have increased their dividend payments for an amazing 50 consecutive years or more. The list is made up of some of the ‘bluest’ of the blue chips, including:
The Dividend Kings index is another excellent place to look for high quality dividend stocks for your core holdings. You can find a complete list of all 16 Dividend Kings (along with analysis) at this link.
Warren Buffett & Dividend Stocks
Warren Buffett is arguably the most famous investor of all time. Warren Buffett started saving and investing as a child. Today he is worth over $70 billion. Warren Buffett holds a highly concentrated portfolio. His top 7 holdings make up about 75% of his total portfolio. Holding such a highly concentrated portfolio is not recommended, unless you are as adept at investing as Warren Buffett (you aren’t, but don’t feel bad. No one is).
All of Warren Buffett’s top 7 holdings pay dividends. Here are his top 7 holdings:
- Wells Wargo (Ticker: WFC)
- Coca-Cola (Ticker: KO)
- IBM (Ticker: IBM)
- American Express (Ticker: AXP)
- Wal-Mart (Ticker: WMT)
- Procter & Gamble (Ticker: PG)
- ExxonMobil (Ticker: XOM)
Four of the top 7 are Dividend Aristocrats (Coca-Cola, Wal-Mart, Procter & Gamble, and ExxonMobil). Wells-Fargo was a Dividend Aristocrat until it fell off the list during the Great Recession of 2007 to 2009. IBM is a Dividend Achiever. American Express has a long dividend history as well; the company has paid dividends regularly dating back to 1987.
I believe it is telling that the most consistent investor of the last 50 years invests primarily in dividend growth stocks. You can learn more about Warren Buffett’s dividend growth portfolio here.
Competitive Advantages & High Quality Businesses
Dividend stock investors should look for high quality businesses with strong competitive advantages. It has worked well for Warren Buffett, and it will work for you as well. Companies that reliably increase their dividend payments year after year thanks to their strong competitive advantages reward shareholders with year after year of growing cash flows.
There are not many businesses that can sustain growth over a multi-decade period. As mentioned above, the Dividend Aristocrats Index (or Dividend Kings List) is an excellent place to find high quality businesses that have been able to grow their earnings and dividends consistently through time.
There are certain types of businesses that are underrepresented in the Dividend Aristocrats index. You will see very few technology companies that make the cut (only ADP and AT&T). This is because the technology industry changes rapidly. It is much more difficult to sustain a competitive advantage in rapidly changing industries. Think about Eastman-Kodak as an example. Their once strong franchise has been made virtually irrelevant thanks to the forward march of technology. Apple is another great example. The company very nearly went bankrupt before its rapid ascension with the iPod, iPhone, and iPad. Industries that change rapidly are not fertile grounds for companies to grow their dividend payments year after year.
On the other hand, slow changing industries such as consumer disposable products, food, and beverages are much easier places to hold a competitive advantage for several decades. Additionally, industries with high barriers to entry and large regulatory burdens prohibit new entrants. This creates a lack of competition which encourages the dominant company in the industry to stay dominant for decades. Examples of this kind of industry include utilities and telecommunications.
Wall Street & Low Fees
Wall Street has just one problem with dividend stock investing: Individual investors can do well themselves without help from Wall Street. Buying and holding high quality businesses that pay increasing dividends does not take an Ivy League educated investment professional. Dividend investing is about buying and holding for the long run. This greatly reduces portfolio turnover. Low turnover means less fees for brokerages.
Dividend investing can be implemented without the help of a financial advisor or investment advisor. Individual stocks can be purchased instead of funds (which charge more fees). When a stock is purchased, it is often held for years or even decades instead of constantly churning trades. All of this means no money for Wall Street. As a result, dividend growth investing has been under-covered by the financial media relative to how effective it is for individual investors.
Dividend stock investing combines many aspects that help to increase returns. Dividend stock investors who focus on the following are likely to compound their wealth and grow their passive income streams over time:
- Low Portfolio Turnover: Do NOT constatntly buy and sell stocks. Look for businesses you can buy and hold for long periods of time. The lower your portfolio turnover, the less frictional costs you have to pay including capital gains taxes, brokerage trading fees, and slippage.
- Dividend Paying Stocks: As discussed earlier, dividend paying stocks historically have significantly outperformed the market. Focusing on dividend paying stocks increases your chances of favorable investing outcomes.
- Low Fees: Look to minimize investment fees. Investing in individual stocks keeps your investment money in your account and not with a financial advisor or mutual fund manager. When you invest in mutual funds, you must pay a fee (often over 1%) to the investment manager. This is money straight out of your pocket (or investment account).
- Have a plan: It is critical to have an investment plan when creating your dividend portfolio. Invest at regular time intervals regardless of the stock market. Create a portfolio allocation plan, and diversify among at least 15 stocks