Of all the investing strategies, dividend investing is probably the most popular and possibly the most profitable. Growth investors may put their money down on the hope of big gains in the future, but income investors can bank on a steady stream of cash while they wait for higher prices.
Getting Paid to Invest
At its most basic, the dividend payment is profits paid out to shareholders. Dividends are normally paid on a regular basis; either quarterly, monthly or semi-annually but can also be made as an unscheduled payment. Dividends are often overlooked as a part of long-term returns but the payouts are responsible for over 40% of stock market returns since 1930. A dollar of dividends reinvested is worth almost $8 at the end of 30 years on an annualized 7% rate.
Besides the obvious advantage of getting a current return for your investment, companies that pay a dividend are normally good bets for financial discipline. Maintaining the regular payout is extremely important as a sign of stability. This means that management must keep a close eye on cash management and only the most profitable projects get the green light.
Dividends are normally announced by the company through a press release. The amount of the dividend and the date of the dividend payment, as well as the date of record establishing who will get the dividend, is released at this time. The ex-dividend date, usually two days before the record date, is important. It is the first day that the stock trades without the dividend so anyone buying the shares on or after the ex-dividend date will not receive the payment.
A very important aspect of investing in a dividend is understanding the tradeoff between the dividend payout and retained earnings used for business growth. A company choosing to payout earnings as dividends is acknowledging that cash would be better used by investors than by the company, almost by definition. That means that every dollar paid out as dividends reduces the company’s potential for business growth.
Important terms and metrics in dividend investing are:
- Dividend yield is the percentage return realized by the investor when the dividend is received. Be wary of companies offering yields too high to be sustainable. This payout level might be unsustainable or could be an indication that the dividend will be cut. Nuclear energy provider Exelon (EXC) was paying nearly 7% dividend yield leading into 2013 and investors couldn’t have been happier. The cash ran out though and the dividend was cut 40% and the stock tumbled more than 20%.
- Return on Equity (ROE) is return attained by the company from operations as calculated by net income divided by stockholder’s equity. The return on equity is used with the percentage of earnings not paid as dividends to find the company’s growth rate. If the company is not retaining sufficient earnings, then the growth rate will have to decrease and the stock price will stagnate. A healthy dividend payment is nice but investors ultimately need stock price growth as well as current income.
- Dividend payout ratio is the percentage of income paid out as dividends. If the company is paying out all its income in dividends, it may not have enough for profitable, price-growing projects.
Thanks to the tradeoff between cash payouts and growth, I like to look for stocks that pay between 25% and 45% of their income as dividends. Depending on the sector, a dividend yield between 2% and 6% can be sustainable without sacrificing growth. Yields above 6% and you really need to keep an eye on profits to make sure the company will be able to keep paying out the dividends.
Diversify your Dividends
Diversification is an often overlooked idea within dividend investing. Investors look only for the highest payouts and end up loading their portfolio with only a small group of industries and sectors. This is because some sectors, being fairly mature and having more predicable cash flows, are more likely to pay dividends. Looking only at higher payouts means your portfolio could be over-weighted to utilities, financials and consumer goods.
Putting together your portfolio without maintaining a diversified range of sectors ultimately will lead to losses. A rise in interest rates will hit the utilities sector disproportionately and we all know what happened to stocks of financial companies in 2009. A diversified dividend portfolio means having income-paying stocks across many sectors.