How to Invest In Dividend Stocks
Investing In Dividend Stocks
The stock market is one of the best ways to build wealth, but not all stocks are created equal. Whether your long-term investment horizon is five years, 25 years, or 45 years or more, your best option for creating long-term wealth is with a diversified portfolio of high-quality income stocks. Learning how to invest in dividend stocks, however, is a lot more work than picking the names with the highest yield.
Before the financial crisis, investors were told it was financially prudent to invest a portion of their retirement portfolio into fixed income investments like Treasuries or Certificates of Deposit (CDs). And why not? Fixed income returns provided investors with stable income; they know what their annual returns will be and can budget accordingly.
All that changed when the Federal Reserve sent interest rates plunging to zero through its quantitative easing efforts. Low interest rates may be designed to help reinvigorate the economy (though the effectiveness is certainly open for debate), but barely-there interest rates have also decimated retirement funds. By taking “income” out of “fixed income investing,” the Federal Reserve has destroyed the retirement dreams of many Americans.
That’s where investing in high-quality stocks that provide dividends come in. There are two ways you can make money on a stock: capital appreciation and dividend yield. Capital appreciation is the increase in the share price and the dividend yield is what the company elects to pay out annually. For example, if a company’s share price increased five percent in 2015 and paid an annual dividend of five percent, the annualized return would be 10%. Adding high-quality dividend stocks to your retirement portfolio is the best way to ensure consistent growth.
Why do companies pay dividends? Because dividends are a great way to attract investors looking for a steady and secure income stream. Dividends also show how financially strong a company is.
How important are dividends to your portfolio? Since 1926, dividends have contributed nearly a third of total equity return, while capital gains have contributed approximately two-thirds. By ignoring high-quality dividend stocks, you could be ignoring additional gains of 33%. That number gets significantly higher when you factor in compounding. (Source: “S&P 500 Dividend Aristocrats,” S&P Dow Jones Indices, last accessed September 14, 2016.)
In addition to investing in quality businesses that pay a dividend, look for those that have a long history of increasing their annual dividend. There are excellent stocks out there that have increased their annual dividends for five, 10, 20, 25, or even 50 consecutive years. That means these companies continue to make a lot of money, no matter what the broader markets or economy is doing. They return that wealth to investors in the form of a dividend. Further, investors can rely on these companies to raise their annual dividends.
Companies that have increased their dividends for at least 25 consecutive years are called “dividend aristocrats.” These dividend aristocrats have outperformed the S&P 500 over the last 10 years by a wide margin.
They have also provided investors with ongoing stability. To help stomach market volatility, high-quality dividend-yielding stocks provide investors with a steady income stream. Whether the markets are going up, down, or sideways, dividends can help off-set the short-term volatility of a market correction, recession, etc.
Granted, this doesn’t mean a dividend aristocrat or any business will continue to raise its annual dividend indefinitely. But if a company has increased its annual dividend for 25+ years, you know it’s part of the corporate culture and they’re going to do whatever they can to ensure that winning streak continues.
How to Invest in Dividend Stocks
So when learning how to invest in dividend stocks, where should investors begin? Companies with a long history of paying a dividend and increasing it annually tend to be larger, well-run companies with an international footprint, consistent growth strategies, and a strong competitive advantage.
Why invest in a big company with a five-percent dividend yield when you can invest in a penny stock with a 15% dividend yield? There is a risk/reward trade-off when it comes to dividend-yielding stocks; the higher the yield, the greater the risk. Is it worth risking all of your capital on an unproven startup for a 15% yield?
High-dividend yields may be attractive when you’re looking at near-zero interest rates and central banks addicted to negative interest rates, but it’s important to understand what you’re investing in and what the risks are.
A stable business that increases its annual five-percent dividend on a consistent basis is more attractive than a business with an eye-watering 15% annual dividend that doesn’t. In fact, companies that grow their dividends are more attractive than those that simply pay a high dividend.
On top of that, stocks that grow their dividend perform better than those businesses that do not pay a dividend, those that do not increase their yield, or those that cut or eliminate their payout.
Where do you find excellent stocks that provide dividend growth and capital appreciation? Everywhere. Stocks with a quarter-century or more of increasing their annual dividends tend to be larger industry giants. You can look at the equities that make up the Dow Jones Industrial Average for starters.
When it comes to investing in dividend stocks, many gravitate to sectors like banks, pipelines, and utilities. But if you’re looking for proper diversification, you might want to consider looking at health care, consumer staples, and consumer discretionary.
But beware: dividends are only as safe as the underlying strength of a company. That’s why it’s important to analyze the financial strength of the company to ensure the dividend yield is sustainable.
Look at the company’s financial health, earnings outlook, and debt-to-equity ratio. The total assets should be greater than total current liabilities; this means the company will not run into any short-term cash flow problems.
And the total payout ratio (dividends divided by net earnings) should be less than 40%. The amount that is not paid out to shareholders is reinvested by the company to promote growth. If a business has a payout ratio of 70%, you know it isn’t putting much back into the company to make money. This ratio does not apply to utilities, real estate investment trusts (REITs), or master limited partnerships (MLPs).
If the Great Recession taught us anything, it’s that cash is king. If a company is paying out out all of its income as dividends, it has no safety net when the economy sours—and it will. If a business needs to rein in its spending because of lower earnings, the first thing to be cut will be the dividend. And angry investors punish stocks that cut their dividends.
The markets may be trading near record levels, but they continue to be volatile and rife with uncertainty. In light of weak economic data and the imminent rise of interest rates, it’s a good idea to look at stocks that have sustainable and growing dividends.
Investing in Dividend Stocks
When it comes right down to it, investing in dividend stocks is more comes down to a lot of common sense do’s and don’ts. That is, look for places where people spend their money when times are good and bad.
If you think the U.S. economy is moving in the right direction, look for consumer discretionary stocks (restaurants, furniture, automotive). If you think the economy is facing headwinds, look at defensive plays—those dividend stocks that make products we use every day (toothpaste, soap, shampoo, cigarettes, etc.).
These kinds of companies have relatively stable stock prices which makes them easier to buy and hold. That’s part of the joy of investing in big blue-chip dividend stocks; it doesn’t require a lot of monitoring.
That doesn’t mean you ignore your portfolio, but it means you probably don’t need to check in three times a day. That’s because businesses that report consistently higher earnings and increase their dividends clearly have a competitive advantage, one you expect will continue.
While it may be tempting to cash in your dividends at the end of every quarter, it’s more important to reinvest all of your dividends. Thanks to compounding, you’ll end up with more stocks and a portfolio that is worth a lot more than if you’d cashed in your dividends.
To make your retirement portfolio even stronger, look for high-dividend-yielding stocks that provide a dividend reinvest plan (DRIP) and/or direct stock purchase plan (DSPP).
With a DRIP, you can reinvest your annual dividends and avoid brokers and their fees. With a DSPP, you can purchase additional shares (whole or fractional) without paying a commission.
Financially solid businesses with growing earnings and revenues that also raise their annual dividend yields are excellent buy-and-hold stocks that will enhance your retirement portfolio over the long run.