Note from Mr. SR: Some investors are laser-focused on “dividend investing” — which is essentially investing in companies that tend to pay out a higher percentage of dividends to their stockholders. I’m excited to share this post written by my friend from 10 Year Target. He explains the advantages of dividend investing, so you can decide if this strategy could be a good fit for you!
Your investing strategy should be based on your own goals, risk tolerance, and self-imposed rules for investing. I personally invest in a variety of ETFs and index funds, including those that would be considered “dividend investing.” You should always consult a professional, fiduciary financial advisor for any personalized investment advice.
My portfolio is diversified. I invest in a lot of different classes and I am always eager to learn more about what is out there. One of the asset classes I have spent the most time on recently is my dividend stock portfolio. I regard dividend stock investing as a great investment strategy for people looking for financial independence, and perhaps especially for when they eventually have reached the independence level.
Read more about asset allocation HERE.
What are dividends?
So what is a dividend? A dividend is a distributed payout from a company to its shareholders. The money is usually a part of the companies earnings (some companies pay out dividends even with negative earnings – more on that later). The amount that is paid out is decided by the board of directors and then approved by the shareholders.
When the dividends are paid out and the frequency is different from company to company. Some companies pay dividends every month, some every quarter, some monthly and others don’t pay a dividend at all. Those that pay out monthly or yearly, often payout in relation to the reporting season.
The amount you receive as a shareholder is related to the number of shares you hold at the record date. When the dividend is announced, it is announced as X $ per share. The day after, the dividend amount is subtracted from the value of the shares to reflect the value of the company being distributed back to the shareholders.
Why do companies pay dividends?
Dividends are paid out to the shareholders as a reward for their investment. Dividend-paying companies are usually big corporations, steady corporations that do not necessarily have a stock price that doubles every two years.
So in order to attract shareholders, they pay out dividends to become attractive. The alternatives to paying dividends are either investing the money for growth or have the money in the bank.
For large corporations it is hard to invest all of its cash and having the money in the bank is usually not a good alternative. Therefore it is better to reward their shareholders. The shareholders own the company after all and should benefit from the profits.
Advantages of dividend investing
Index funds are perhaps the easiest way to invest. You put money in and you have invested in a variety of stocks without having to take into consideration what stocks you want. So why should you use a dividend investing strategy?
Cash is king
First of all, you have the cash flow. Cash is king, right? Dividend investing gives you cash on a regular basis. As an investor, this gives you cash on hand in case you find new investment opportunities. And if you are a person living your financial freedom dream you can choose to take the cash and live off that. That way you do not have to sell your stocks to pay yourself.
In general, companies paying dividends are solid companies that have a lot of cash. This is a good metric for a safe investment. By going for a dividend stock strategy you will automatically find solid and healthy companies when doing the screening. Dividend investing is usually not viewed as especially sexy either so the stocks are less volatile than many other stocks.
I borrowed the chart below from the Motley Fool. It shows the performance of the S&P by price movement (blue line) compared to price movement + dividends (orange line). As you can see the dividends boost your returns substantially over time.
What to look for in a dividend investment
When people first get involved with dividend investing they tend to look for stocks that pay out a high dividend in percent of the stock price. I do not recommend this. You need to investigate why they pay out such a high dividend. There are multiple reasons for high dividend % that does not indicate a healthy company.
- The dividend could be a one-time payout meaning you cannot expect the same amount next time
- The stock price may have fallen a lot since the dividend announcement. Then the high % means the stock is in bad shape and in a negative trend.
- A high dividend may be a desperate attempt from the company to keep or attract new shareholders when it is hard to find other attractive aspects of the company.
- By paying a high dividend, the company will burn up their cash and need to lower their dividend in the future.
That being said, a high dividend can be a good thing if other parameters are also in place. These are the parameters you need to look at in addition to the dividend amount:
How much does the dividend increase over the years? A dividend strategy is a long-term strategy. You want the shares you buy this year to increase its return every year. So look for companies with increasing dividends.
One day the stocks you bought that returned 2% the first year may return 20%. But look out – the growing need to be sustainable. A year without growth or falling dividends can be seen as a sign of slowing business.
How long have the company paid out a dividend? If a company has paid out a dividend every year for 30 years, it is more likely to pay out dividends next time than a company that has paid dividends for 2 years.
Dividend payout rate
How much of the revenue is paid out as dividends? If too much of the revenue is paid out as dividend it is hard to maintain this level over time. On the other hand, a low payout rate will surely mean a low amount.
When it comes to dividend stock screening it is all about sustainability. You need all the parameters to be in a comfortable range. You want a healthy company and you want to avoid a dividend cut. It may seem trivial, but it can indicate underlying problems and the market doesn’t like that. This will affect the stock price. And even though you want dividends, you cannot forget about the stock price.
Important dividend related dates
The date the dividends are declared by the board of directors.
The date you must hold stocks in order to be eligible for the dividend payout.
The ex-dividend day is the day where new shareholders will not receive dividends (until next time). The value of the dividend per share is subtracted from the price of the stock on this date.
The payment date is when the dividend is sent to the shareholder’s account.
An easy way to start your screening is to look at what is called dividend aristocrats. The dividend aristocrats are companies that are part of the S&P500 and have increased their dividends for 25+ consecutive years. In other words, these include both the dividend growth and payout history parameter mentioned above.
If you want to look closer at dividend aristocrats I suggest you head over to the SureDividend website.
Another group is the Dividend Kings. These have 50+ consecutive years of dividend increases.
DRIP is short for Dividend Reinvestment Plan. Many companies offer the shareholders an opportunity to reinvest their dividends automatically. This is what DRIP is. So each time dividends are paid out you receive more shares rather than cash. The brilliant thing about DRIP is that you are issued shares without having to pay any brokerage fees.
What is your investment strategy? Do you do dividend investing or plan to do so?
This post was originally published by 10 Year Target and is re-published here with permission.