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In today’s investment world, we are presented with a number of strategies we can employ to increase our net worth. Sometimes this can be a blessing. But for most, it’s downright overwhelming. It’s already a difficult feat to dive into the world of DIY investing. Now we have to choose which route we want to go down?
I’m not going to dive into the details of every investment method, we’d be here all day. Instead I’m going to talk about an investment strategy that is often used by people who have a less than normal risk tolerance, and aren’t willing to stick their necks out for some extra gains.
I would consider this method the most popular investment strategy there is, and if you encounter an experienced investor, you can all but guarantee they have a decent chunk of their portfolio allocated to these stocks.
What is this investing strategy? It is dividend investing.
In this post, I am going to show you why dividend investing should be your top investment strategy if you want to have long term success investing in the stock market.
Your Ultimate Guide To Dividend Investing
Investing In Income Stocks
Income investing, or as most like to call it, purchasing dividend stocks is an investment strategy that doesn’t necessarily focus on capital appreciation of the stock itself, but more on the money you receive in the form of dividends from owning the stocks.
So what is a dividend? Simply put, a dividend is a certain allocation of a companies profits that it issues to shareholders. These may be monthly, quarterly or even annual payments.
When we think of dividend stocks, we think of established blue chip companies that have been around the block. These companies have exhausted all their high potential growth opportunities and are now willing to generate profits for their shareholders in the form of a dividend at the expense of company growth.
This is one of the key concepts when looking at the differences between a dividend stock and a growth stock. The reasoning behind a growth stock not paying a dividend is simple. When you’re looking to expand your business, it doesn’t make much sense to dish out a healthy portion of your revenue to shareholders does it?
No, you want to reinvest that money back into the business to continue to grow. But when you are a mature company and aren’t interested in growth, paying a dividend makes sense.
Why Choose A Dividend Investing Strategy
Why should you choose a dividend investing strategy? The simple answer is better long term returns. Take two companies, one that pays a dividend and one that does not. By investing in the company that does not pay a dividend, you are at the mercy of the stock market.
If the stock price rises by 4%, you earned 4%. But if the stock price drops by 4%, you lost 4%.
But when you invest in a company that pays a dividend, the math changes completely. If they pay a 3% dividend and the stock earns 4%, you made 7% on your investment. If the stock price drops by 4%, you only lost 1% since you made 3% from the dividend.
And I didn’t just pull that example out of the air to make the case for a dividend investing strategy.
Here is a chart of the last 23 years comparing the annual return of the S&P 500 Index to the Dividend Artistocrats.
As you can see, you would have fared very well by using a dividend investing strategy. Let’s look at the growth of $10,000 in each investment during this time.
By investing in the S&P 500 Index, your $10,000 would have grown to over $90,000. Not bad at all. But that same investment in the Dividend Artistocrats would end up being worth over $145,000!
So What Should I Look For When Buying A Dividend Stock?
There are a few metrics you need to look at when you are considering a stock purchase based on its dividend. However, keep in mind that although these numbers provide an indication of how solid a company’s dividend is, they don’t really speak directly about the health of the company itself.
Buying a company strictly for its dividend is an error a lot of new investors make. If a company has a dividend yield of 5%, but the stock is falling at a rate of 4.5% a year, you’re really getting nowhere, especially if your dividends are in an account that is subject to tax.
This is because even though you earned 5% from the dividend, you lost 4.5% on the stock price. And since dividends are taxed, you end up losing money overall.
Now that I got that out of the way, here are a couple key numbers I look for when purchasing a dividend stock.
The Payout Ratio
I consider this the most important number you can look at when sifting through a list of dividend stocks to purchase.
The payout ratio is simply the amount of earnings expressed as a percent that the company is paying to shareholders.
There is no “ideal” payout ratio, but there are a few things you need to look at. If a company’s payout ratio is high, let’s say anything more than 60%, it can be a warning sign that the company is currently issuing too much of their earnings to shareholders.
At one point this company’s payout ratio may have been lower, but due to poor performance over the years, their earnings have fallen and their dividend has stayed the same. I typically like to avoid companies with a payout ratio of 60% or more.
But this isn’t the case in all situations. It’s important to look at the company’s track record over recent years and check the overall health of the company. If they aren’t struggling and have strong fundamentals, a high payout ratio can be simply an excellent investment opportunity.
The Dividend Yield
This is simply the return on investment in the form of dividend payments you can expect from purchasing a dividend stock. Keep in mind that the dividend yield does not take into consideration capital appreciation or depreciation in the form of stock price movement.
Calculating dividend yield is quite easy. It is simply the price you purchased the stock at, divided by its annual dividend price. So if a stock is priced at $20 and issues a $1 dividend annually, your yield is 5%.
Contrary to what most new investors do, I look at the dividend yield last when considering a purchase. Overall I would consider the dividend yield of a company to be somewhat of a value trap for new investors.
A 10% dividend yield is nice, but you know what they say about things being too good to be true? In most situations, this is the case.
As the price of a stock falls, the dividend yield typically goes up. Let’s take our $20 stock from above and use it as an example. Right now it has what would be considering to be a fairly healthy yield of 5%.
But let’s say the company goes through a rough patch, revenues are down, contracts are lost and the stock falls to $10.
If their dividend stays the same, their yield will now be a whopping 10%. New investors looking at dividend stocks may make a blind purchase of the company based on its yield alone, even though they are investing in a company in turmoil.
What do companies typically do when they are in financial trouble? They cut expenses.
And one of the first ones they will look to cut is their payouts to shareholders. So the investors who bought the high yield stock for the 10% yield are suddenly only earning a 5% dividend because the company slashed its dividend.
Consistent Dividend Payouts
This, along with the payout ratio, is what I would consider to be the most important aspect when looking at dividend stocks.
Remember when you first went to the bank to get a loan? The bank was probably a little hesitant to give you money. Maybe they charge you a higher interest rate, or simply flat out refuse to loan you money. Why?
Because you simply had no history. You were asking a financial institution to take a blind chance on you, hoping that you’ll make your payments.
With dividend stocks, the roles are reversed and you are the bank. Are you going to give your money to a fresh company that hasn’t even had 5 years of stable dividend payments? More than likely not.
Are you going to give your money to a company that has slashed it’s dividend 3 of the last 5 years due to the fact they have had to go into debt to pay their shareholders? I sure hope not.
It’s imperative that you look for companies who have at the absolute minimum kept their dividend payments the same over the years. Optimally, you want to be investing in companies that have done nothing but raise dividend payments.
Luckily for you, many companies regularly raise their dividend annually. So you shouldn’t have a hard time finding companies that are raising their dividends.
Your Dividend Investing Strategy
If you take the advice given in this post, you want to start investing in companies who:
- Have a history of paying dividends
- Are not in turmoil and might slash their dividend
- Are not paying out too much of their earnings in dividends to shareholders
And while it is not required, you ideally should stick to companies that regularly are increasing their dividend each year. This will help you to offset the impact of inflation on your investment.
What Are The Best Dividend Stocks?
This is a tough question to answer because every dividend growth investor is looking for something different. Some investors might only want the most stable companies and are OK with a lower dividend yield.
Other investors might be pure dividend growth investors and require stocks that raise dividends on an annual basis. And still other investors might only focus on high dividend stocks.
Because of this, there is not a one size fits all type of best dividend stocks list. With that said, there are some stocks out there that are good choices for building a dividend investing strategy around. Here are a handful to look into.
- Johnson & Johnson (JNJ)
- 3M (MMM)
- Coca Cola (KO)
- Leggett & Platt (LEG)
- Exxon Mobil (XOM)
- PPG Industries (PPG)
The best place to start building your dividend investing strategy if with M1 Finance. There you can create a customized portfolio of dividend paying stocks and pay no commissions at all! Click here to get started with M1 Finance!
There are a ton of things that factor in to purchasing a dividend stock. These three concepts will get you started, but it is crucial that you have an overall idea of how the stock market works and how to analyze a companies financial situation.
Ratios are good to use as a screener to maybe separate the wheat from the chaff, but once you’ve narrowed your list down to a select few based on these metrics, you need to dig deeper and analyze the companies health as a whole.
Just as a guitar is only as good as it’s player, a dividend is only as good as it’s company that is paying it.
Author Bio: Dan Kent is a writer and co founder of Stocktrades.ca. A DIY investor for 8 years now, Dan has a combination of dividend, growth and real estate investments in to his portfolio and is looking to continually grow his net worth. You can check his website out at stocktrades.ca or follow him on Twitter at @Stocktrades_CA.