Buying stocks that pay dividends is one of the more popular and successful income investing strategies. A portfolio of dividend stocks and other income producing assets can provide financial independence after you retire, and possibly allow you to retire early.
Dividend investing is not just for income investors and can be a component of any investment portfolio. In this post we discuss the factors to consider when investing in dividend stocks, popular income investing strategies and some of the common mistakes to avoid.
- What is dividend investing?
- Why invest in dividend stocks?
- How to invest in dividend stocks?
- What to look for when investing in dividend stocks
- Popular dividend stocks and the dividend aristocrats
- Why a high dividend yield could be a warning sign?
- Dividend investment strategies
- How to find out if dividend investing is right for you?
- Income investing mistakes to avoid
What is dividend investing?
Dividends are a means for companies to distribute part of their profits to shareholders. When companies begin to mature, the returns they can earn on reinvested profits begin to decline. It therefore makes sense to distribute profits to shareholders. A dividend investing strategy seeks to build a portfolio of stocks that are able to continue paying dividends, and to continually increase the size of the dividend.
Dividend investing is just one form of income investing. Other income generating investments include preference shares, bonds, and real estate. Dividends are similar to other income producing assets like savings accounts and real estate investments. This means that the benefit from the compound interest effect is correlated to interest rates.
Why invest in dividend stocks?
The ultimate goal of most income investing strategies is to create enough income to become financially independent. The income stream from a portfolio of dividend paying stocks, bonds and rental properties can eventually replace a salary. Dividend investing is also another way to diversify an equity portfolio. While stock market investing is typically associated with capital growth, there are several reasons to also consider yield. It’s a well-known fact that stocks have outperformed other asset classes over the long term.
What is less well known is that much of that outperformance comes from dividends. Companies that pay regular dividends are often more defensive and less volatile. Adding dividend stocks to a portfolio can therefore reduce volatility and the impact of corrections and bear markets. Like other passive income strategies, building a dividend portfolio is something you can do while you have a full-time job.
How to invest in dividend stocks?
Dividend investing is a long-term investing strategy, and it’s important to develop a process to select stocks and manage your portfolio. The first step in this process is to generate a watchlist of stocks that pay dividends. Stock screeners can be used to create a list of stocks with a dividend yield greater than a threshold percentage; 1 or 2% is a good starting point. The next step is to do some basic fundamental analysis to narrow the list down to stocks for your watchlist. Finally, you will need to rank the stocks, or identify the price or yield that will trigger a buy.
Mutual funds and exchange traded funds (ETF) investing is another approach to dividend investing. This obviously requires less work on your part, but it’s worth noting that dividend funds have not typically performed very well. You will have greater flexibility if you manage your dividend portfolio yourself.
What to look for when investing in dividend stocks
The most important step in selecting dividend stocks is to narrow the list of dividend paying stocks down to those worth investing in. The following factors are worth considering when doing this.
The key to successful dividend investing is finding stocks that can maintain or preferably increase their yield sustainably over time. A company that pays all its profits out as a dividend has no margin of safety if it runs into trouble. Conversely, a company that only distributes part of its profits will have extra cash available should it be needed.
The dividend payout ratio indicates the percentage of profits a company pays out as a dividend. Typically, a payout ratio of around 30 to 40% is considered safe. The inverse of the cash payout ratio is the dividend cover ratio which shows you how many times over the dividend is covered by earnings. Both metrics will give you an idea of how sustainable a dividend is.
Dividends are paid out of profits, so profitability is essential. Companies with wide and sustainable margins usually have something unique about them. If a company has what’s known as a moat, competitors will not be able to compete on price and its margins will be sustainable. A moat may take the form of intellectual property like a strong brand or patents, or high barriers to entry. The wider a company’s moat, the safer the dividend will be, and the more chance there will be of the dividend being raised each year.
There is little point owning a stock with a generous yield if the stock price is at risk of falling 50%. Valuation is therefore important and you should compare a few of the stock’s valuation metrics to those of its competitors and the market as a whole. Growth investors must sometimes buy stocks at a premium. But this is seldom the case for dividend stocks which perform best when they have been purchased at a fair price and not at a premium.
Other factors to consider
Slightly less important, but worth considering are the company’s return on capital, growth, and debt. Companies with double digit revenue growth will be more likely to raise their dividends over time. Consistent revenue growth also proves the company still has a competitive edge or operates in a growing market. A company’s return on capital (ROC) or return on equity (ROE) indicates whether or not it has a strong business model which is a good indication of long-term profitability. A ROE of 15% or higher is often a good indication of a strong business.
Finally, as with any company the strength of the balance sheet is good indication of sustainability. Ideally the debt to equity ratio should be less than 50%. Perhaps more important is that it should not be increasing. If debt is increasing, the company is borrowing money to pay dividends – so investors are really just borrowing from themselves.
Popular dividend stocks and the dividend aristocrats
The following are examples of popular dividend investing stocks based in Europe and the US. The fact that these are popular, doesn’t make them the best dividend stocks, as this will change from time to time.
- Siemens AG (SIE) is one of the world’s largest and most diversified technology companies. It yields over 4% and benefits from consistent margins and diverse revenue streams.
- Novartis AG (NVS) which is based in Switzerland is one of the world’s largest pharmaceutical makers. It has strong margins and a ROE of 23%. The company is worth $211 billion and yields over 3.5%.
- GlaxoSmithKline plc (GSK) is a UK based pharmaceutical giant with a large portfolio of products. It has a strong operating margin of 21% which allows it to comfortably yield 4.6%.
- BP Plc (BP) and other oil producers have been under pressure since the oil price collapsed. However, the world’s large oil giants like BP have historically been amongst the most popular dividend stocks. This stock is now trading at a 10-year low which puts its dividend yield at over 10%.
- Walmart (WMT) is one of the world’s largest and most successful retailers. Its e-commerce business is also growing rapidly, meaning its business is not at risk like many other retailers. Walmart is worth $352 billion and yields 1.74%
- Procter & Gamble (PG) is well known as a defensive and diversified blue-chip company. The company owns hundreds of well-known household brands which it sells around the world. The 2.8% yield is slightly lower than other stocks in this list – but it’s also a safer proposition.
- Intel (INTC) is another technology company with strong intellectual property, and its chips are found in millions of devices sold each year. Intel yields around 2%.
- Exxon Mobil Corporation (XOM) is another oil giant which has been a favorite for dividend investors for a long time. Despite the lower oil price, the company is still worth $200 billion and yields over 7%.
- Enel Americas S.A. (ENIA) is the largest energy distributor in South America. The company has strong margins and a virtual monopoly in many of its markets. Enel shares yield over 7%.
- The Coca-Cola Company (KO) has one of the strongest brands in the world and has an economic moat that no competitor has managed to breach. This edge has allowed it to consistently yield over 2%.
Another good place for dividend investors to start their search for stocks is the Dividend Aristocrats list. Companies on this list belong to the S&P500 index and have increased their dividends for each of the last 25 consecutive years. The list is widely available on the web and currently includes over 60 companies.
Why a high dividend yield could be a warning sign?
Like any form of investing, there are a few investing myths and warning signs to look out for. When it comes to income investing the biggest red flag is a high dividend yield. Exactly what is considered too high a yield varies from sector to sector. So, why might a high dividend yield be a red flag? Companies sometimes use high yields to attract investors – but the yield may be unsustainable.
If the business does not generate enough cash flow it will have to cut the dividend, issue new shares, or borrow money in the future. All of these can lead to the share price falling. A very high yield is the dividend investing equivalent of a value trap. The bottom line is that an attractive yield doesn’t make a stock a good investment. The same also applies to municipal and corporate bonds.
Dividend investment strategies
When it comes to income investing, the choices and possibilities are endless. The number of choices can be overwhelming, and there is a risk of trading too often. For this reason, it’s a good idea to come up with a dividend investing strategy and stick to it. If your goal is to create a reliable income stream, then your dividend investment strategy should focus on high quality companies, rather than on yield or growth. If your risk tolerance is a little higher, there are some other approaches to consider.
Dividend growth investing is a great long-term strategy. The idea is to find companies with the potential to increase the size of their dividends over time. The best candidates are companies with a good balance between profitability and growth potential. If you are looking for dividend growth, you don’t need to worry too much about the starting yield. If you buy a stock with a yield of 1%, but the dividend grows at 50% each year, the yield on your initial purchase will soon be 3 or 4%. This will also typically result in the share price rising rapidly too. Even if the stock never trades with a high yield, the dividend can still grow quite rapidly.
Another approach is to look for cheap dividend stocks. This is a form of value investing where you look for dividend paying companies trading on low valuations. Frequently you will be looking at companies in the process of a turnaround or restructuring. This type of stock picking approach requires more skill and knowledge than other methods. Lastly, you can focus on REITs – real estate investment trusts. This is also a specialized approach but can be very lucrative if you put in the time to learn about the industry.
How to find out if dividend investing is right for you?
There are two factors to consider when deciding whether or not dividend income investing is the right approach for you. These are your interests and the phase of your investing journey. Firstly, the biggest capital gains are often made before a company begins paying dividends. You shouldn’t expect to make large capital gains, though quality dividend stocks do typically generate steady returns over time.
If your interests are with exciting startups and tech companies, you may find dividend investing quite dull. Some smaller companies do pay dividends, but they tend to be in the defensive sectors rather than the growth sectors. Dividend investing is also a long-term approach, and not well suited to those who want to trade actively.
The other consideration is where you are in your career and your investing journey. Typically, investors focus on capital growth early in their career, and income closer to, and during, retirement. However, if your goal is to become financially independent in the next decade or so, it may already be time to begin building a portfolio of dividend paying stocks. Even if your focus is not on dividends, an income investing portfolio can still form a component of a larger portfolio.
Income investing mistakes to avoid
There are several common income investing mistakes to be aware of and avoid where possible.
- Chasing high dividend yield
- Overlooking of tax implications
- Assuming false safety
- Trying to time the market
- Neglecting diversification
Chasing high dividend yield
The first, and possibly the most common is chasing yield. There is often a temptation to continuously switch into stocks with a higher yield. Chances are there will always be stocks with higher yields than those you own. But, as mentioned before, yield is not everything. Over time, owning high quality stocks with sustainable dividends is more effective than chasing yield.
Overlooking of tax implications
Another mistake is to overlook the tax implications. For US taxpayers, most dividends are taxed as “qualified dividends”, which means the tax rate is lower than it is for ordinary income. However, some dividends are taxed as “ordinary dividends” which means the ordinary income tax rate applies. If you hold a stock for less than 60 days before it pays a dividend, you will be taxed at the ordinary rate.
The way dividends are taxed depends on where the company is listed, as well as the investor’s country of residence. Dividends you receive from offshore investments may also be subject to dividend withholding tax. Your broker should be able to clarify the taxes applicable to any dividends you receive.
Assuming false safety
Dividend stocks can be more defensive than stocks that don’t pay dividends. However, assuming that all dividend paying stocks are the safest stocks to buy is a mistake. Every stock needs to be carefully considered on its other merits.
Trying to time the market
Market timing is challenging at the best of times. Trying to time the buying or selling of dividend stocks can be even more challenging. Dividend investing is a long-term investment strategy and making predictions about short term price movements is unlikely to add value.
Owning dividend stocks is not a substitute for diversification and asset allocation. There will be periods when dividend stocks will underperform, and exposure to other asset classes will reduce portfolio volatility at these times. This is when hedge funds like Catana Capital’s Data Intelligence Fund, and other alternative assets can be of value.
Conclusion: Dividend investing as long-term investment strategy
Income investing with dividends is just one way to generate a passive income – but it’s probably the easiest way to get started. Furthermore, finding good dividend paying stocks is a skill that can be developed over a long period of time. The time you invest in building an income portfolio in the early years can be very gainfully rewarded later.