Dividend stocks offer something that no other stocks can match–an almost immediate return on your money in the form of a dividend payment. What’s more, building a portfolio of dividend stocks can provide the best of both worlds for investors–growth of your capital (capital appreciation) as well as a steady stream of income (dividends).
So what is dividend investing, and why would you want to follow it as a strategy for investing your money? Is it right for everyone, or is it just for older folks who need income off their investments? What is the track record for dividend investing in the past, and most importantly, is there a reason to think dividend investing will perform well in the future? Finally, how do you get started in dividend investing easily?
What is a Dividend?
First, let’s start with the basics: what is a dividend? A dividend is simply a share of the company’s profits that gets paid out to investors, usually on a quarterly basis. Consider the following fictional story:
Lucy, your plucky neighborhood entrepreneur, decides to open a lemonade stand. But Lucy’s lemonade is no ordinary thing–it captures the hearts of all who try it, and over time becomes very popular.
People from all over the area begin re-arranging their commutes so that they can drive by Lucy’s stand. Soon she expands her operations and has thousands of locations all across America. Over time, Lucy becomes the latest billionaire success story and gets featured on Forbes magazine.
So, what would Lucy probably do with this success? Well, since it would be wise for Lucy to hire an experienced management team to run a large business like this, Lucy’s next step is likely to step away from the business to focus on herself, her family, and maybe some philanthropic endeavors.
But assuming Lucy doesn’t want to sell her stake in Lucy’s Lemonades, how does she get income to support herself without taking a salary? She might be a billionaire on paper, but if it’s all tied up in the company’s stock with no income stream, Lucy is broke for all practical purposes.
The answer is simply for the business to pay Lucy, its owner, a share of the profits. That payment is called a dividend.
The rest of the profits are reinvested back into the business so that it can grow, and the management team of Lucy’s Lemonades will decide the dividend payment amount over time, taking into account the profits available and the company’s plans for future growth. After all, Lucy wants the whole world to get to taste her amazing lemony liquid over time.
What is Dividend Investing?
Picking stocks based on their dividends is often called dividend investing. However, most investors do not simply look at the dollar amount of the dividend, but instead they calculate the dividend yield of the stock. Why? Because the dividend yield tells you how much income you can expect for every $100 of stock you buy, and more importantly allows you to compare the income streams of different stocks and even against bonds, CDs, real estate, and other investments.
To calculate the dividend yield, simply take the dividend payment per share, multiply it times four (if quarterly), and then divide by the share price.
Here’s a simple example. Let’s say Lucy’s Lemonade trades for $100 per share and pays a quarterly dividend of $1.25. By multiplying the dividend by four you’ll get an estimate of the annual income in dividends. In this case, the annual income is $5.00. Then simply divide that by the price to get the dividend yield.
($1.25 x 4) / $100 = 5% dividend yield
Therefore, dividend investing employs a focus on income (i.e. dividend yield) in its stock picking. For some dividend investors, the yield is the most important aspect of a stock, while for others, it’s just one of many factors they look at. Either way, generally speaking an income investor is trying to maximize the income stream for their stock portfolio over time.
Does Dividend Investing Work?
The track record for dividend investing, as compared against a broad stock market index like the S&P 500, is mixed.* Some strategies have shown significant out-performance over time. Others have mostly mimicked the total return of the market, but with the caveat of potentially better performance in market downturns. In a few other cases, returns have lagged the broader market.
It would seem the devil is in the details.
Take the S&P 500 Dividend Aristocrats strategy, for example. This ETF tracks a select group of companies that have paid dividends for over 25 years.* What’s more, companies that qualify as “dividend aristocrats” have even managed to grow their dividends consistently over that period as well. That consistency and financial strength has paid off well for investors as well, with a 12.29% average annual return since 2013. However, when compared with the broader market, that return is actually pretty much the same as the S&P 500.
There is some evidence, however, that stocks that consistently pay and grow dividends perform better in market downturns. In one study, the dividend aristocrats outperformed by an average of 2.93% in the last five market corrections. To me, this result isn’t that surprising, given that companies with long and stable dividend histories tend to be financially strong enterprises, which would attract investors during bear markets.
However, if you go all the way back to the early 1990s, you will see some serious outperformance from the dividend aristocrat strategy. Take a look at the following chart:
Bear in mind that this outperformance is achieved simply by tracking the S&P 500 Dividend Aristocrats Index, which doesn’t include a robust analysis of the companies that are selected. Basically, Standard and Poors (“S&P”) simply selects about 40 companies that are already part of the S&P 500, and that “have increased dividend payments each year for at least 25 years, and meet certain market capitalization and liquidity requirements.”
Wouldn’t a dividend investing strategy with a basis in deep fundamental analysis fare even better?
What Are the Tax Implications of Dividend Investing?
Taxes are an important consideration in any investment strategy, because paying unnecessary taxes can really eat into your returns. As the saying goes, it’s not what you make that matters; it’s what you keep.
Most dividend-paying stocks will be taxed at qualified dividend rates, which range from 0% to 20%. These are the same rates as long-term capital gains, so at least in theory, there’s no penalty for having to pay taxes on dividend income. However, it’s important to consider that you can control when you take capital gains, at least to some degree. You can do this by choosing carefully when to buy and sell your investments, and in general by keeping your portfolio turnover as low as possible.
In contrast, dividends are set by company management, so you have no control over the amount or timing of your taxable income. Of course, if the stock is held in a tax-deferred retirement account (IRA, Roth IRA, 401k, etc.), taxes are not a concern, since the account is already tax-deferred.
However, I would encourage investors not to let taxes turn you off from dividend investing, because while capital gains may offer more flexibility, they are also much more speculative than dividends. There’s no guarantee that capital gains will materialize, and, while dividends are technically not guaranteed either, they are significantly more predictable.
How to Invest in Dividend-Paying Companies
Many investors look for high dividend yields because they want (or need) income off their portfolios to pay their expenses. However, simply investing based on dividends without carefully researching the company itself can be a mistake.
Just look at General Electric (GE). As recently as 2017, the stock price was in the 30s and paying a dividend yield around 4%. Since then, however, GE has run into some financial problems and the stock is now hovering around $8 per share. Even worse for income investors, in 2018 GE had to cut its dividend to one penny per share.
This happens more often than some income investors realize, I’m afraid. It’s important to realize that there’s nothing guaranteed about a dividend. Just because a stock has a strong dividend yield or a long history of paying dividends, it means nothing if they undergo financial difficulty.
In fact, in today’s low-interest-rate environment, it’s easy for income investors to gravitate from CDs and bonds (paying next to nothing) to dividend-paying stocks because they need more income. However, it’s important to remember that stocks, by their very nature, are more aggressive than bonds and CDs, and lack the protections that fixed income investments provide.
At the end of the day, it doesn’t matter what the dividend is, bondholders get paid back before stockholders in the even of bankruptcy.
For that fundamental reason, it’s important to do research on the company itself before investing, to verify whether the company is on strong financial footing or not.
There are many more factors involved in dividend investing than I can go into here, but here are some key considerations for income investors:
- Focus on financially healthy and profitable companies. Companies that pay a dividend must first prove out their business models by showing sustained profits, for that reason dividend investors usually manage to avoid the most speculative areas of the market.
- Consider companies that not only pay steady dividends but also increase them over time. These businesses demonstrate a tremendous level of financial discipline and consistency. Knowing that you have to have the cash available each quarter to pay shareholders will force management to invest only in projects it feels confident in a strong return on capital.
- Don’t just focus on yield. Remember that there are basically three things companies can do with their profits: pay cash out to shareholders (dividends), buy the company’s stock (stock buybacks), or reinvest in the company. Stocks with significant free cash-flow and profits who choose to pay dividends might be tacitly admitting that they cannot find good growth opportunities to reinvest the profits. If that’s the case, it may be just a matter of time before competition finds a way to take market share.
- The pay-out ratio is important. The pay-out ratio measures how much of a company’s profits are paid out in dividends. Among blue chips, AT&T (T) pays one of the highest dividend yields in the market today, at around 6%. That represents a payout ratio of 58%, which means approximately 58% of company profits get paid out to investors, leaving over 1/3 of profits to be reinvested into growing the business.
- Look to buy companies at good prices. Stock investing, like any other type of investing, is as much about the price you pay as about the future performance of the investment. For that reason, also consider the valuation of the company before building a position. You can use valuation metrics like the P/E ratio, P/S ratio, or book value to gain insight into this.
How to Get Started Easily
As you can see, dividend investing is an attractive investment strategy for many reasons, and it’s no wonder why it’s so popular among investors. However, successful dividend investing requires more than just identifying stocks with high yields; it involved careful analysis to select companies with strong yields, financials, and future business prospects.
So how does a busy professional get started in dividend investing without spending all day reading company financials? Well, there are several options: mutual funds, ETFs, or a tailor-made, automated investing service like Emperor Investments.*
Emperor Investments is an online investing service that custom designs and manages portfolios of dividend-paying stocks for investors. Their process combines the convenience and low cost of automation with human analysts who personally review each company before it is included in the portfolio.
This combined approach has demonstrated strong investment performance in the past, even when compared to the broad market index (S&P 500).
The result is a robust approach to dividend investing and direct ownership of dividend paying stocks without having to do it all yourself. Sign up today and receive 6-months free with a balance of $500 or more!
Editor’s note: special thanks to Emperor Investments for inspiring and sponsoring this post. Please click here to learn more.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value. Indices are unmanaged and investors cannot invest directly in an index.
Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
Emperor Investments does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
The results of forward-testing does not represent the results of actual trading using client assets and should not be considered indicative of the skill of the adviser. Forward-testing (aka paper trading) fails to address the broad market’s impact on individual securities and generally does not account for cost like slippage, commissions or fees. Forward-testing often includes “formfitting” which is the ability to select ideal entry and exit points.
This article mentions various investments and investing strategies; however, the mere mention of an investment, investment platform, security, or investment method does not constitute investment advice. Please read SMN’s disclaimers for more details.