Dividend Investing for Beginners
Guide to Dividend Growth Investing
Dividend investing involves buying stock in companies that pay out a portion of their earning to shareholders in the form of dividends. Dividends are a way for you as the investor to get a regular stream of the distributable profits from the dividend paying public companies you own.
There are two types of dividends:
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Regular dividends: The most common type of dividends, these are paid on a regular basis (typically quarterly) and funded by company earnings. If it’s a good dividend paying company, you will see the dividend grow over time.
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Special dividends: A one-time event, special dividends may be paid when a company has an especially profitable quarter, divests a division or business unit, or to take advantage of tax policy changes. Special dividends are not that common, but you will see them on occasion with certain companies.
Part of understanding whether you can count on dividend investing being a profitable and sustainable passive income stream is examining why companies pay dividends. Simply put, it’s their responsibility. The job of the chairman and board of directors is to run the company in the interests of its owners, that is you, the shareholder.
The board of directors has a fiduciary responsibility to maximize shareholder value. This means if the company is generating profits, the board of directors must make sure that the generated cashflow is put to good use towards its goal of maximizing shareholder value. There are basically two options for the board to achieve this. The generated cashflow can either be put to work in the organization (e.g., internal projects or acquisitions) or it can be returned to shareholders in the form of dividends (or stock buybacks). What drives this important decision is whether management believes, and the board agrees, that the generated cashflow will earn a significant return when used to fund internal projects. A good example is Amazon where management believes its profits will earn greater returns for shareholders if they are re-invested into R&D for new innovations like drone delivery or in scaling its burgeoning advertising business. They are choosing the re-investment path over returning generated profits to shareholders via dividends. There is no doubt their investors are happy with this capital allocation decision, judging by the close to 120,000% (as of August 2019) increase in the stock price of Amazon from the time of its IPO in 1997.
Whether to pay dividends is not a binary decision, since profits can be allocated to both internal projects and paid out as dividends to its shareholders. For example, after a “no dividend policy” throughout Steve Jobs’ second CEO tenure at Apple (1997 to 2012), Apple’s dividend history took a sharp turn back to paying dividends once Steve Jobs stepped down and Tim Cook took over as CEO. Despite a ballooning cash hoard during the later stages of his tenure Jobs famously and stubbornly resisted paying a dividend.
“We know if we need to acquire something — a piece of the puzzle to make something big and bold — we can write a check for it and not borrow a lot of money and put our whole company at risk,”
Jobs once said to a shareholder who asked why Apple didn’t pay dividends.
Fast forward a few years, Apple now sports a decent dividend yield of 1.54% (as of August 2019). Realizing there are not enough attractive internal projects or acquisitions to re-invest all its profits, Apple has been returning some of this cash to its shareholders in the form of dividends. All the while, Apple continues to invest in several moonshot type projects including its long rumoured self driving car project and augmented reality. The result for shareholders - an 18% annualized return over the last five years, with the dividends making up about 8% of this total return. What I love about the Apple story is it dispels the myth that investors must choose between growth or income.
There are a lot of other myths about dividends that are worth busting to further illuminate what dividend investing is and isn’t.
The biggest myths about dividend investing
Dividend investing is foolproof
Just like value or growth investing, once you’ve purchased a basket of dividend growth stocks your job is not done. You will need to monitor your dividend portfolio and act if “the facts on the ground” change. The company may face financial difficulties resulting in dividend cuts or eliminating the dividend payment altogether. For example, during the financial crisis of the late 2000s a bunch of dividend aristocrats from the financial services sector were forced to cut their dividend. A dividend aristocrat is a major achievement for dividend growing stocks. at least 25 straight years of increased dividend payments. However, even royalty can fall.
The warning signs I look for to tell me if there is risk of a company cutting or eliminating its dividend include a change in the company fundamentals (e.g., increased debt), inability to transform to major shifts occurring in its industry, a decelerating dividend growth rate, among other signs. When I see these signs, it triggers me to revisit the sustainability of the company’s dividend to determine if my money is best invested elsewhere.
Dividend investing eliminates the need for fixed income
While dividend investing can provide a substantial stream of income over time, it is not a replacement for another important asset class to include in a well-balanced investment portfolio – fixed income. Fixed income investments generally pay a return on a fixed schedule until its maturity date. Bonds may be the best-known fixed income asset type, but guaranteed investment certificates (GICs), money market funds and fixed income exchange-traded funds also qualify.
Fixed income assets should be included in every portfolio because of the unique qualities they offer that no other asset type can offer, including dividend paying companies. They offer less risk, diversification that is much appreciated in times of a stock market crash, an income component and a small amount of capital appreciation potential. While fixed income assets offer lower return potential than dividend equities, you need to hold multiple asset types to diversify and manage your investment risk. This is a building block of successful investing. Opinions do vary widely in terms of how much of your portfolio should be allocated to fixed income vs stocks, dependant on age and risk tolerance. I personally advocate for a smaller fixed income allocation earlier on in your investing journey, increasing over time as you age and get closer to retirement. My portfolio consists of about 15% invested in fixed income assets which many financial advisors would consider too aggressive, but I’m ok with the risk that carries given my age and current market conditions.
Only invest in dividend paying stocks
While I am a big advocate for dividend investing for many good reasons that I will explain shortly, it should not be your only investing style. I view growth investing to be an important component to super charge your wealth creation. Growth investing involves investing in young or small companies who are expected to grow at an above-average rate as compared to their peers or the overall market. Growth companies do not pay dividends as they have a long runway of growth that needs to be properly funded to fully capture the opportunity.
Investing in growth companies is the only way I know how to hit a home run on the stock market. And, while singles and doubles can produce a good batting average, home runs are what make super stars. Of course, taking big home run swings brings more risk of striking out, so you must do it wisely. To be literal this means starting with the right investment hypothesis, research and buying what you know, and allocating a small portion of your total investment portfolio to taking this sort of measured risk. It’s important to consider your age. The younger you are and further away from your retirement, the more runway you have to recover from losses that may arise from the riskier style of growth investing.
The higher the dividend yield the better
Bigger is not always better. Just take the “Super Size” craze that McDonalds started as an example, resulting in too many cardiac arrests and a stinging documentary called Super Size Me that showed the negative physical and psychological effects of “too much”. Similarly, stocks with the biggest dividend yields are not always better. In fact, high dividends well beyond the industry average can be a big warning sign of trouble ahead – whether the yield is up because the stock price has been decimated recently or because the dividend is just not sustainable. Either of these scenarios would likely foreshadow a dividend cut.
Why bother with dividend investing?
Let’s face it, as investors we are all after the juicy returns promised by the next big Tech IPO. If only we could go back in time and have the foresight to invest in Amazon, Google or Netflix. While I am a proponent of taking the odd well researched and measured risk, chasing 10 baggers only is foolish. We need to plant seeds that while they may not offer 10 bagger status, if well selected should produce market beating returns through a combination of dividend income and appreciation. This is where dividend investing comes in.
There are lots of good reasons to begin a lifelong love affair with dividends. With their predictability dividends will be there for you when the market betrays you. Dividends will protect you and keep you safe during market lows – the best dividend growers (dividend aristocrats) will still pay you even when the market tanks. Governments often treat dividend income in a preferential manner when it comes to taxation. Dividends can grow over time, which is often a positive indicator of a company’s financial health and growth. Plus, many dividend paying companies have dividend re-investment programs that act as an accelerant to compound growth and help you buy more shares when the price is lower. But the biggest reason why I love dividends is simple – high dividend yielding companies outperform companies with low to no dividends.
Dividend Investing: What is the pay-off?
As depicted in the diagram below(1) , history has shown high dividend yielding companies, on an annualized total return basis, have outperformed the lowest dividend yielding companies by 3.68%, and the S&P 500 by 2.45% from 1957 – 2012.
The payoff for you adopting an investment strategy that favors high and sustainable dividend yielding equities is significant. Assuming you start with $10,000 to invest at age 24 and an annual contribution of $10,000 per year invested in high yielding dividend paying companies until the age of retirement of 65; you will add an incremental $700K+ to your retirement portfolio versus what you would have realized just investing in an S&P 500 index fund.
[1] The Enduring Qualities of Dividends, Lyle B. Schonberger, May 21, 2013; Ameriprise Financial