DIVIDEND INVESTING: IS IT A GOOD STRATEGY?

“If you want the recipe for getting rich in the stock market, here it is: find stocks with above-average appreciation potential and safe and growing dividends and buy them at attractive prices”

These are the famous words given by Warren Buffett, who is considered one of the world’s top successful investors. He advises us to choose stocks that have safe and growing dividends.

As you know cash dividends are the additional amounts given to the stockholders by the company taken from its profits. Investing in a company based on its dividend is really helpful because it could able to grow our money as well as generate income. Here through this post, I will show you how it is useful to invest in cash dividend stocks by giving you proper examples and comparisons. I also will help you to get a better perspective on dividends from which you could able to understand which company you want to choose if you are willing to invest in a company mainly with the aim of dividends.

Before getting to the post I am giving some basic knowledge regarding dividends.

  • Dividends are the amount given to the stockholders by the company taken from its profits.
  • The dividend given by a company is determined by the company’s board of directors.
  • The investors who had bought stocks before the ex-dividend date is applicable to get the determined dividend.
  • Not every company provides dividends and not at the same rate.
  • Giving dividends to common stockholders is not a mandatory thing for a company. So they can stop giving dividends when they like. ie; There is no guarantee about dividends
  • Most of the companies give dividends on a quart-year basis. But there are companies that give dividends on a yearly and monthly basis too.
  • The dividend yield is the percentage of dividend given per current share price dividend yield = (dividend per share/price of a share)*100
  • The company’s ability to pay dividends is a sign of its good corporate health

Now let us understand by an example how profitable is it to choose stocks based on dividends.

For this let’s take the table which shows the annual stock price change and annual dividend history of the S&P 500 index.

S&P 500 historical return and dividend table
Stock price change and annual dividend history of the S&P 500 index

Now it’s time to assume that we had bought S&P 500 stocks on some time just before 31st December 2009. for convenience, let’s assume that the price of stock then was almost the same as that of the 2010’s opening price. That is $1133. We bought 10 stocks with an overall amount of $11330.

Here’s the table which shows our money growth(yearly capital appreciation).

example table
Example table

At last, we got $39013.300 on selling the stock in 2022.

So our profit is $39013.300 – $11330.000 = $27683.3

the total amount we got from dividend = 233.836+272.170+318.813+364.351+401.666+438.192+461.797+499.862+532.348+600.740+603.007+624.716+667.127

= $6018.625

In comparison with the capital appreciation, it is almost 21.74 percent. This makes our overall profit:

Overall profit = 27683.3 + 6018.625 = $33701.925

Now you most probably would be appreciating dividends. This is the only case of a $11330.000 investment. You can increase your investment amount and thereby make a fair income using dividends.

And from the table, it’s clear that even though the S&P 500 index showed a decline in stock value in the years 2015, 2018, and 2022 and no change in the year 2011, the dividend seems not to be affected. This is why most investing legends advise as to buy dividend-providing stocks. As we are getting income though in the time time of market decline as well.

WHICH INDUSTRIAL SECTORS PAY CONSTANT DIVIDENDS?

Here’s the list of sectors that commonly provide consistent dividends:

  • Basic materials
  • healthcare
  • pharmaceuticals
  • oil and gas
  • utilities
  • Banks and financial

Commonly, technological sectors don’t provide dividends as they want to do take research for further growth and to come up with new innovative products/services. They will utilize the maximum profit they earn for these instead of paying dividends.

In startups and new IPOs also, you may not be able to get dividends.

But there are a few companies that provide consistent dividends that belong to the technological sector like AT&T Inc.

RISKS OF DIVIDEND STOCKS

It is as important to point out the risks as to glorify the benefits. Dividend stocks, having a lot of advantages also have risk factors as well. While selecting stocks with the aim of dividends, we also have to be well aware of the possible risks and drawbacks.

1. REASON FOR LOW GROWTH OF DIVIDEND STOCKS

Constant dividend-paying companies’ capital appreciation per year, commonly, would not be as much as the others. This is because of the intuitive fact that dividends are paid mostly by those companies that are beyond their growth stage. On saying conversely growing companies (Growth stocks) usually don’t pay dividends to the investors of common stocks.

Growing companies, that show greater annual growth in the money you have invested, will utilize their excess profit for further research and further growth than splitting it to the common stockholders in the form of dividends.

As we all know that cash dividend is the amount a company gives to its stockholders from the company’s profit, it’s not much of a deal to understand that the dividend payers are not utilizing much of their profit for further research and growth. They want to stay in the current – almost stable state.

2. COMPANY STOPS PAYING DIVIDENT

This is another predicament. Suppose we have selected a good, consistent, and juicy dividend payer to invest all our money hoping mostly on the frequent income offered by dividends. What if the company decided to stop paying dividends after we have invested in the stocks? There can be many reasons for this which includes any financial or economic crisis or their new plans and goals. Well we are helpless because dividend payment is not a mandatory thing for the company and of course all know that a dividend-paying company can stop doing it any further according to their wish.

What makes the condition worse is that many of the prevailing stockholders, just like us, will start selling their stocks as they are also dividend lovers. This sudden action decreases the sock value tremendously. Thereby giving us a huge loss!

Now the question you have may be something like this: “Hey, did anything like this happened earlier at any time?”

My answer to this is “hell yeah!”

For example the financial meltdown in 2008-2009. Almost all banks stopped paying dividends thereafter (the funniest fact is that those banks were stable and consistent dividend payers for more than hundred years!).

So it is simply not perfectly predictable to know when the company will stop paying dividends as it is not a must thing to do pay.

3. WHY IS IT NOT GOOD TO SELECT COMPANY BASED ON DIVIDENT YIELD?

The price of stock and dividend yield have an inverse relationship (ie: they are inversely proportional)

dividend yield = dividend / stock price

From the equation, we can see that when the company stays in a stable dividend (for example the company ABC gives $0.5 per share always), then the increase in stock price decreases the dividend yield and vice versa.

Thus, the sequential increase in the dividend yield of a company implicitly says that the stock price is sequentially decreasing (bearish trend)

So, selecting stocks according to the increase in dividend yield may not be a wise idea.

Tip: you can evaluate a dividend stock on the basis of the following ratios:

  • Dividend payout ratio
  • Dividend coverage ratio
  • Net Debt to EBITDA
  • FCFE(Free Cash Flow to Equity), etc

WHAT DOES HIGH AND LOW DIVIDENDS SHOW?

A high dividend given by a company can be viewed from two perspectives:

  1. The company doesn’t want to grow further. They want to stay in its current state. The company is giving high dividends because they want to split the entire profit with its stockholders. They don’t have (or they are not willing) to do any innovative things to grow the company or to do research.
  2. The company got a huge profit. The company has got a significant profit that they shared with the stockholders in the form of dividends

Similarly, a low dividend can also be viewed from two perspectives:

  1. The company is doing great in its growth. The company may be utilizing its profits for new research and implementing innovative ideas for a more remarkable growth.
  2. The company got very low profit/no profit/loss the company doesn’t have enough money to give the usual dividend. This may be because of loss or very low profit.

Here it’s all upon you to do fundamental researches on the company you are concerned with to choose the correct perspective.

CONCLUSION

Investing in dividend stocks is a good idea for creating income as well as wealth. But choosing the right companies is really essential. As you see in the first part of this article, Warren Buffett also stands on the opinion of choosing dividend stocks. And of course it has become a crucial criterion for most of all value investors for picking stocks to go long.

SYAMRAJ MS

SYAMRAJ MS

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