The reason most people steer clear of investing in stocks is summed up in one word – volatility. Stock prices move around like a roller coaster and most people simply lack the stomach to see their wealth go for such a wild ride. The stock market, for most people, is a heady mix of anxiety and exhilaration.
But investments shouldn’t be an exciting adventure. Instead, the more business-like your investments the better you are likely to perform over the long term. Good investing should actually be rather boring, says Adam Nash, CEO of Wealthfront.
Which is why some of the most successful investors prefer putting their money in companies that slowly payout a dividend every year. Available and predictable income holds a lot of value in the stock market and usually that’s where the smart money tends to focus. Take Warren Buffett, for example, who’s managed to create an impressive list of some excellent dividend stocks over the decades.
So, here’s everything you need to know about dividends and the strategy you’ll need to create a rock-solid income portfolio for yourself.
You might be wondering why dividends are special? After all most fast growing companies never pay a dividend and some that do actually pay out very little.
The most interesting feature of dividends is the certainty of cash flows. See, most companies earn a profit after every quarter of generating sales. Part of this profit is held back at the company and reinvested in things like better equipment, bigger properties, or research. But there’s a chance that money is still leftover after the reinvestment. This is called free cash flow, and the company has a few options on what to do with it:
- Hold the cash on the books (in case an attractive acquisition or project comes along in the future)
- Pay it back to shareholders.
Usually a company will pick a combination of the two options. Part of the cash will be held back on the books, while part of it is deposited directly into the shareholders account. The shareholder in this scenario receives tangible proof that the company she invested in is profitable and healthy. After all, how would the company be able to pay her if it wasn’t performing well.
That is a simple logic to follow. It’s like the old adage – “A bird in the hand is better than two in the bush.” In other words, being paid a dividend is better than reading a report about the profits made every quarter.
Do Dividends Make A Difference?
If you’ve followed along with the reason companies pay dividends, you may be wondering why the companies don’t just hold the cash and use it to expand. It’s true that a lot of penny stocks, fast-growing tech companies and risky biotech firms don’t pay a dividend. These are businesses that are either betting on high rates of growth or operating in risky industries that are unpredictable.
A lot of investors invest in high risk, fast growing companies and there’s nothing wrong with that. But over the long-term, stable dividend paying companies are likely to outperform. Research show that over half of the stock market’s returns are due to the dividends paid out by companies. Tangible cash allows investors to benefit from the magic of compounding.
Investing in blue-chip stocks that can promise a healthy return may sound boring, but it’s a lot more likely to make you wealthy. It’s a slow burn strategy that eventually leads to some phenomenal results. But to pull it off correctly, you’ll need a solid dividend stock investing strategy.
Dividend Stock Investing Strategy
It’s not difficult to understand what dividends are and how they’re paid out. But investing in dividends doesn’t mean simply looking for the highest yield. If you buy a stock for $10 and it pays out $3 every year, that’s a pretty high dividend return. But you’ll need to dig deeper before you put money into the investment.
A good dividend stock investing strategy involves research. It is an attempt to understand the sustainability and growth potential of the dividend. Going back to our earlier example, if the $10 stock you bought paid a dividend of $3 in the first year your return would be 30%. However, the stock could have a bad year and the management could decide to cut the dividend altogether the next year. This changes the basis on which you invested. Now the yield is 0%.
To prevent such a situation you need to dig into the dividend and figure out if the company has enough of cash on hand to pay it. You also need to figure out if the company is likely to run into trouble over its debt or be unable to grow the rate of dividends over the long term.
Here are the steps involved in the dividend stock investing strategy:
- Long term prospects
Start off with the long terms prospects for the industry or company you pick. If you like a certain consumer staples company, make sure there will be enough of demand for its product and services ten or twenty years down the line. A company will not sustain a dividend if it cannot sustain sales. This step is tricky, since you need to understand the nature of the business and the industry, but is an absolutely essential part a good dividend stock investing strategy. A number of energy firms cut their dividends after oil prices fell over the past two years. Conocophillips, for example, cut its dividend from 74 cents a share to less than 25 cents earlier this year.
- Financial health check
A great product won’t translate to great dividends if the company’s financial health is deteriorating. Think about companies that borrowed too much money and declared bankruptcy despite having a great business model and wonderful product. Run a health check on the company’s finances before investing in the stock.
- Management reputation
A good dividend stock investing strategy takes the management’s reputation into account. See, the buck stops with the management since they can decide how much or if at all a dividend must be paid. Pro-investor managers usually agree to pay out a high dividend. Or they make the effort to explain to shareholders why dividends won’t be paid.
But if the management has a reputation for suddenly cutting dividends without explanation, that adds to the risk of the investment.
- Dividend history
The only way to judge the management’s track record is to look back the company’s dividend history. If the company has a long history of healthy and growing dividends it’s a good sign. It means future dividends are likely to follow a similar trend. Perhaps look for dividend paying stocks that are part of curated list like the S&P 500 Dividend Aristocrats Index.
These four steps are crucial for any dividend stock investing strategy.
Dividends are genuinely powerful. A dividend stock investing strategy is likely to make a massive difference to your performance and wealth. It’s a slow and steady process that could take years. A high dividend yield isn’t enough. You need to look for companies that have shareholder-friendly management, a history of growing dividends, a healthy balance sheet, and prospects for future growth. If you are patient enough to dig deeper and research the dividend paying stocks on the market, you’ll find some absolute gems that you can add to your income-generating portfolio.