The Dividend Investor
An income with your capital gain, the best of both world's
Dividend investing is a popular investing strategy which uses fundamental analysis in order to determine a company's ability to pay a dividend reliably.
Dividend investing is an income investing strategy and the primary goal of the dividend investor is to receive an income stream, rather than a capital gain. The basis for this strategy is to purchase shares in a dividend paying company at an attracted price, thus providing a desired yield on the capital invested.
Only good quality dividend paying companies with a history of increasing revenue and producing a profit are considered, as dividend investing requires the company to continue to pay the dividend well into the future.
An example of a dividend paying stock is AmTrust Financial Services, Inc. NASDAQ:AFSI with its fundamental data shown below in Table 1.
Fundamental Data: AFSI
|Year||Income $Billion||EPS $/share||ROE||Dividend $/share||Book Value $/share||Employees|
Referring to Table 1. above, the dividend has increased every year over the last five years. Also the company has increased its revenue every year over the last five years. While the earnings has dropped over the last year it's still significantly higher than five years ago. The ROE (return on equity) is quite good and the company continues to expand its workforce with the number of employees increasing. This financial information shows that AmTrust Financial Services, Inc. is in pretty good shape fundamentally and is likely to continue paying dividends into the future.
Dividend investing tends to somewhat go out of vogue during strong bull markets, as the capital gains made from growth stocks can be irresistible to investors. During these buoyant times, the investors that continue with dividend investing tend to be investors that are very risk adverse.
Dividend investing is generally considered one of the lowest risk strategies for investing in the stock market. The mere fact that dividend investing seeks out only those companies that are fundamentally sound and pay generous reliable dividends means that most stock candidates tend to be older mature companies that have been in business for quite a long time, and as such the risk of these companies running into financial difficulties is relatively low.
One issue the dividend investor needs to keep in mind is that of interest rates. In a low interest rate environment, it is not difficult to find good quality stocks with dividend yields higher than the interest rates that can be obtained from a bond. However, in a high interest rate environment, the dividend yield available may well be less than that obtained from bonds or even bank interest rates.
This then leads to another issue when interest rates are high; a dividend paying stock's price will still appreciate in the long-term in line with economic growth, whereas the principle value of bonds remains unchanged. That is, at the expiration of the bond the bond s only value is the interest income, whereas a dividend paying stock offers both the dividend income and some long-term capital growth.
In addition, the dividend payment per year increases over time in line with the company's profits increasing over the long-term. Thus the effective dividend yield per year actually increases over the long-term based on the original capital invested, whereas a bond's interest payments remain static rather than increasing over the long-term. The article Dividends and Coupon Payments compares the payments received from a dividend paying stock and treasury bonds over the last decade.
One of the main criticisms of dividend investing is that the dividend yields are very low during strong bull markets. This is primarily due to the fact that stock prices can increase more rapidly than the companies' profits (and thus their dividends) during a strong bull market.
Basically there are two ways for the dividend investor to obtain a reasonable dividend yield.
Firstly is to purchase stocks that pay reliable dividends but without any significant growth prospects as these companies do not need to reinvest their profits to finance any growth. Utility companies and manufacturing companies tend to have limited grow potential and as such have no requirement to finance any significant expansions. Thus they tend to pay out a large portion of their profits as a dividend.
Secondly is to wait for the stock price of a low dividend yield company to drop to a level where the dividend yield is attractive. Generally the stock's price will only drop low enough when some event caused investors to sell out, which could be anything from a company reporting less than expected profits, to a generally poor economic environment. Dividend investors make good use of bear markets to top up their portfolios with quality dividend paying stocks that have been sold down heavily and are now paying decent dividend yields.
Historically, the stock's price of most dividend paying companies at some point will drop to level that will provide a decent dividend yield and this is where dividend investors add these stocks to their portfolio.
At some point the stock price will drop low
enough to provide a decent dividend yield
Reliable dividend paying stocks do not generally include growth stocks. However they can still provide good long-term capital growth in line with the growth in the economy which when combined with the dividend income can provide a respectable return on the capital invested.
The characteristics of a good dividend paying stock include the following.
Characteristics of good dividend stocks
- Fundamentally sound with a history of reliable revenue, profits and paying dividends.
- Mature companies that have been in business for quite some time are best. Newer companies that have been in business for only a couple of years have not yet proved their reliability.
- Generally are not growth companies as they tend to reinvest their profits.
- Low dividend yield companies can provide decent dividend yields when they are out of favor as the stock prices are now sufficiently low to provide a decent yield.
- Typically, both the current and forecast PE ratios are low.
- Insiders such as directors and key employees purchasing shares rather than selling shares. These insiders know the company and their own buying provides confidence that the company is fundamentally sound.
Good dividend yields can be obtained when the stock's price has been declining. This makes some stock investors nervous as investors tend to be more comfortable buying a stock when its price is climbing rather than falling. The main point here is to check that the dividend paying stock is still fundamentally sound.
While dividend investing is not as popular nowadays as it was in the past, this style of investing still has a significant following with its relatively low risk being one of its main attractions along with a regular cash payment income stream. Combine this with some long-term capital growth and it's not difficult to see why risk adverse investors are still attracted to this investing strategy.
Dividend investing is generally suitable for buy and hold portfolios and most dividend investors rarely ever sell a stock. They will typically add to their portfolio when a stocks price drops to a level where its dividend yield becomes more attractive.
The added bonus that the dividend investor enjoys is that the dividend income per year increases over the long-term in line with growth in the economy, thus the dividend yield actually increases over time based on their original capital invested.
The annual growth in Dividend Yields
The annual increases in dividends is more important than the initial dividend yield
Most stock investors think of the dividend yield as being a static yield, whereas in fact the dividend yield is generally a value that increases over the years. The calculation for the dividend yield uses the stock's purchase price (or the proposed price if planning to buy the stock) and the current years dividend payments.
However, in the years after acquiring the stock, the annual dividend payments will likely be higher, so doing the yield calculation (which uses the stock's original purchase price), now gives a higher yield than what the yield was when the stock was first bought. That is, the dividend yield in future years reflects the original monetary investment, not the future stock price. The future stock price is only used in the calculation if the investor intends on buying additional stock in the future.
This compounding effect is best illustrated with an example.
Example: Digital Realty Trust, Inc. NYSE:DLR paid a dividend of $3.52 for the 2016 fiscal year which gives a dividend yield of 3.6% at the end of 2016 (stock price of $98.26 on Dec 30, 2016).
The dividend yield of 3.6% for Digital Realty Trust, Inc. in the above example is not overly impressive, however this does not allow for any annual growth in dividends and hence dividend payments. Digital Realty Trust, Inc. has historically increased its annual dividend payments by 7% per year on average.
The following table illustrates what happens to the yield for Digital Realty Trust, Inc. if the annual dividend payment continues to increase by 7% per year over the next 10 years.
Table 1. Increase in dividend yield over 10 years
Note: The stock price in Table 1. above was assumed to increase by 7% per year in line with the expected dividend increase. The portfolio value is based on 100 shares and increases every year by 7% due to the stock price increase. The annual dividend payment is NOT added to the portfolio value.
While the original dividend yield for Digital Realty Trust, Inc. was only 3.6%, the yield in 10 years time is now around 7%. This comes about because the annual dividend payment in 10 years time is $6.92 which is based upon the original 2016 stock price of $98.26. If the investor were to buy stock in 10 years time, then the dividend yield on this future stock purchase would still be 3.6%, which leads to the next issue.
For the above example, in 10 years time the stock price is no longer $98.26, but would now be around $193. Thus not only is the dividend investor now receiving an annual cash payment of around 7% of the original capital invested, but the investors portfolio value has also increased at a rate of 7% per year due to the stock price increasing.
While the total return in the first year is 10.8%, which comprises of 3.8% from the annual dividend payment and 7% capital growth. The total return in 10 years time is 14.1%, comprising 7.1% dividends and 7% capital growth. Thus as time goes on, the effective annual return actually increases, due to the dividend payment increasing.
The figures used in the above example are readily obtained from the stock market during a bull market. While bear markets will temporarily reduce the capital growth until the next bull market starts, the dividend investor still receives the dividend income.
Good dividend stocks are usually associated with older more mature companies, which are not the high profile 20% per year growth stocks which attracts the attention of investors (especially beginner investors). But these dividend stocks are relatively low risk and for the long-term stock investor they still provide a respectable total return.
The dividend investor may now be wondering whether better use can be made of the cash dividend payments that the investor receives every three months. The simple answer is there is!
The strategy is generally known as dividend reinvestment. This is the process where additional shares are acquired using the dividend cash payment received, so that every three months additional shares are added to the portfolio. So when ever a company pays a dividend, more shares equal to the value of the dividend are acquired for that stock. The astute stock investor may recognize this strategy as a form of Dollar Cost Averaging. Reinvesting dividends and making additional contributions is a strategy that savvy investors use to accumulate their wealth over the long-term.
There are several methods that a stock investor can obtain additional stock, with the obvious one being to simply buy more stock through your broker in the normal way. While this approach is generally cost effective for professional and experienced stock investors who use direct access brokers (whose brokerages charges are normally very low), for most investors using online brokers, the brokerage charges can make this strategy ineffective.
Fortunately there are other cost effective approaches available to the stock investor that makes dividend reinvesting profitable.
Companies often provide a direct means of acquiring additional shares directly from the company. This is usually known as a DRIP (dividend reinvestment plan). The basic idea is that the stockholder registers with the dividend paying company's DRIP plan and the stockholder will then receive additional stock instead of the cash payment from the dividend. The main advantage of doing so is that most DRIPs have very low or have no costs involved. In addition, most DRIPs allow fractional share acquisitions. For example, the dividend value might provide the investor with say 8.42 shares, rather than just 8 shares.
Most stock investors are not even aware of
DRIP′s – Dividend reinvestment plans
There are some tax considerations the investor needs to consider. First, most DRIPs do not allow investors to hold stocks in an individual retirement account (IRA) and thus the investor still needs to pay tax on the dividend amount, even if no cash payment was physically received. This comes about because the investor did receive the payment; it was just used by the company to acquire the additional shares for the stock investor. Second, investors need to keep track of the purchase prices for all the DRIP acquired shares in case any stock is sold in the future for capital gains tax purposes.
The power of reinvesting the dividends comes in the form of compounding returns. This is best illustrated using the Digital Realty Trust, Inc. example from table 1. above and reinvesting the dividends to buy more shares rather than taking the dividends as a cash payment. This is illustrated in table 2. below using 100 shares to begin with.
Table 2. Reinvesting dividends over 10 years
The investor should note that with DRIP plans, the investor acquires fractions of a share, not just the whole number of shares.
For comparative purposes, the information from table 1. and table 2. are summarized below in table 3.
Table 3. Summary comparison of Table 1. and Table 2.
Referring to Table 3. above, Dividend Yield 1. refers to dividends taken as cash payment and Dividend Yield 2. refers to dividends reinvested to acquire more shares.
The dividend yield based on the 2016 stock price increases more when the dividends are reinvested as this provides more shares that pay the dividends. In other words, the dividend amount paid is greater when dividends are reinvested.
The 10 year portfolio increased by 97% over 10 years when the dividends taken as cash payment and increased by 161% when reinvested. This is to be expected when the dividends are not placed back into the portfolio.
As can be seen from these results, reinvesting the dividends has a compounding effect on the investors' portfolio value. After 10 years, the investor would have around 136 shares even though the investor started with 100 shares. This is the power of compounding.
The decision as to whether to reinvest the dividends is dependant on each individual investor's personal circumstances. From experience, what tends to happen is that the younger investors that are currently receiving an income from employment tend to reinvest their dividends to acquire additional stock. When they become older and retire, they tend to stop reinvesting their dividends and instead now use their dividend payments as supplemental income during their retirement years, which by now can be a substantial amount.
By now the stock investor is probably starting to see why investors are attracted to dividend investing and in particular, dividend reinvestment plans.
These seemingly dull and boring stocks with relatively low growth rates that pay measly dividends are not impressive over the short-term by any means. But over the long-term the total returns actually start to become quite significant. The trick with dividend investing is not to focus on the short-term returns. For the aspiring dividend investor, this style of investing does require a very long-term commitment, and that means decades, not years! For those investors that are in it for the long haul, this style of investing can provide a very comfortable lifestyle in the future.
Finding Good Dividend Stocks
How to find good dividend stocks for your portfolio - with capital gains
The dividend investor needs to thoroughly understand the benefits and risks associated with this style of investing, and that the dividend investor has the patience required for this style of investing.
Constructing a suitable portfolio is essential to being a successful dividend investor. A common trap for dividend investors is to buy a stock that currently has a high dividend yield, only to later find that this was a once-off payment that is not being repeated in the future.
These once off high dividend payments are known as "special dividends" and are generally a redistribution of some of the company's capital back to the stock holders. While these special dividends are attractive, they do artificially inflate the current dividend yield. Thus the dividend investor needs to carefully check whether the upcoming dividend payment or any recent dividends included any special dividends.
The ongoing maintenance for a dividend portfolio is fairly minimal, with most of the effort needed being in setting up the portfolio. Once setup, the portfolio does not require day to day attention.
Generally, dividend investors will diversify their portfolio across varies industry groups rather than concentrating on one or two industries. Also, holding a higher number of stocks with smaller share quantities reduces the impact on the portfolio if any one stock reduces or eliminates its dividend. Diversification and position sizing are key components of risk management and are extremely important with dividend investing.
The dividend investor needs to obtain a good balance between reducing investing risk and the time needed to set up the portfolio. Holding 10 to 20 stocks is generally suitable for most investors. Holding more than 20 stocks marginally reduces the risk further, but this now increases the effort needed to set the portfolio and also starts to require more time to monitor the portfolio.
Finding Good Dividend Stocks
Dividend investors look for good quality stocks that are both fundamentally sound and are paying an attractive dividend yield. One factor to be considered is the current dividend yield compared to the estimated future dividend yield. Some stocks may be currently paying a lower dividend yield, but have a higher annual increase in earnings and thus can provide higher dividend payments into the future.
Online stock brokers generally have some type of fundamental screening application that dividend investors can use to obtain a list of potential dividend stock candidates.
- The first step is to run a screen to filter and sort the stocks that pay a dividend. This list can be filtered for a desired minimum dividend yield.
- The next step is to check each candidate for its dividend payment history. Stocks that do not pay dividends regularly and consistently should be excluded from the list. Also stocks that have only paid a dividend over the last year or two should be excluded. A long stable reliable history of paying dividends increases the likelihood that the company will continue to pay a decent divided into the future.
- Market capitalization now needs to be carefully considered. Basically, the smaller companies are more likely to reduce or eliminate their dividends but they may provide higher dividend yields. What range of market-cap values to accept is dependant on each individual investor's personal circumstances?
The next step is to filter this list for stocks that are fundamentally sound. Even though the stock is currently paying a dividend, the investor needs some reassurance that the company can continue to pay its dividend and it can not do this if it is running into financial difficulties. The following basic criteria can be used.
Criteria for future dividends
- The tangible net assets over the last three to five years should be increasing, which shows financial strength. The more years of historical tangible net asset value that's available, the more accurate the long-term picture will be. Company's where the tangible net asset value is declining over the years are using up their working capital and/or depleting their assets; these are companies with financial problems.
- The current ratio is 2 or more. That is, the current assets are more than twice the current liabilities. Higher ratios are preferred, which means that the company does not need to rely heavily on short-term financing.
- The annual EPS for the last three to five years are all positive. The more years of historical EPS that's available, the more accurate the long-term earnings picture will be. It is preferable that the annual EPS is generally increasing year after year, however most companies will have a poor year here and there. The point here is that the general profit trend is upwards rather than downwards.
- The annual revenue for the last three to five years is not declining. The more years of historical revenue that's available, the more accurate the long-term picture will be. As with EPS, the general trend should up upwards.
- Must have positive free cash flow, the larger the number the better. This cash flow gives the company the ability to weather difficult operating conditions.
Selecting which Stocks to buy
By now, the list only contains those stocks that have been reliably paying a dividend and are fundamentally sound which increases the likelihood that the company can continue to pay a dividend into the future. These are the most important criteria for a good dividend stock.
The following are more minor but serve to enhance the proposed investment.
Selecting the Stocks:
- Stocks with declining profit margins are not desirable as this indicates that the cost to produce the revenue is increasing.
- Stocks with a low current PE ratio that's not negative are desirable.
- Any analysts estimate upgrades or any current quarterly earnings that exceeded analysts forecasts are desirable.
- Any insider buying or at least no insider selling is desirable.
- Buy recommendations by analysts are desirable, but sell recommendations are not that important.
Once the final list is completed, then the stock investor needs to determine which stocks to select from this list. To a certain extent this depends on how many stocks are in this list.
For the stocks that meet the above criteria, then the stocks with the higher dividend yield would probably be the wiser choice as the dividend income received for the capital invested is higher.
Stock investors who are intimately familiar with the industry that a particular candidate belongs too are at an advantage. These investors can more readily determine whether a company's product or service is still in strong demand or whether some new technology from a competitor may be now dominating the industry.
It is generally better for the stock investor to be choosy and only include the best candidates in their portfolio and exclude the marginal candidates. Hastily filling a portfolio with marginal candidates only increases the risk. The portfolio can be built up over time by more carefully selecting only the best stocks.