A Beginner’s Guide to Dividend Investing

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Dividend investing is a form of passive income that comes from publicly traded companies that regularly pay their shareholders. But in order to live off your dividends, you will need a large sum of money to generate a meaningful income as the yields are only 2-3 percent on average, according to historical data.

Why Invest in Dividend Stocks?

Proponents of dividend investing suggest that this is the way to get rich slowly. In addition, investing in companies known for higher yields compared to their peers in the same industry are believed to be a relatively safe bet—i.e., they are solid, mature business entities and thus more resilient in the event of a market crash and economic recession.

While it is possible to enjoy meaningful income from dividends, take note that you’ll need a lot of capital. To put this into perspective, a typical stock portfolio yields 3 percent on average and so a $1,000,000 investment can only generate $30,000 annually. Of course, you can enjoy the magic of compounding interest if you reinvest your dividends in your portfolio.

Nonetheless, companies with high dividend yields may offer another benefit: growth in investment value in the form of increasing stock prices. This is particularly true if they don’t give all their profits to shareholders but instead allocate a portion to business expansion, i.e., reinvesting in themselves.

A good number of well-entrenched companies or Blue Chips have high dividend yields because they are heading toward the end of their rapid growth, or there is simply no opportunity at the moment that could help them expand their business. Consequently, they share profits with their shareholders through dividends.

The ability to give cash bonuses on a regular basis is seen by some investors as a good indicator that a company can stay on top of its profitability. Nonetheless, savvy investors and money managers make sure that they only pick companies with strong underlying fundamentals, meaning they have solid revenues and earnings, high return on equity, decent profit margins, a high probability for future growth, and other similar data that shed light on their current and future value.

Exceptions to the Rule

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While a good number of dividend-paying companies are in a secure financial position, take note that this is not always the case. In fact, some companies might maintain their high dividend yields despite struggling to keep their finances afloat due to a fear that they may spook their investors and cause a dramatic decline in their stock price.

To minimize the risk involved in dividend investing, savvy investors do not pick companies solely on the basis of which can provide the highest yields. For these people, the underlying fundamentals—such as the free cash flow, quality of management, economic moat, and market share—remain the most critical factor when making any investment decision.

Pros and Cons of Dividend Investing

It may sound like a paradox, but the dividends are not the end all and be all of dividend investing. The most critical goal is to preserve your capital by only picking companies with strong fundamentals. While it is true that all securities come with some level of risk, the odds are in your favor if you practice due diligence.

Oftentimes, dividend investing might be an ideal choice for someone with a low appetite for risk. After all, Blue Chip companies are known to provide higher dividend yields than their smaller counterparts and have proven themselves to be resilient amidst economic downturns.

Furthermore, the stock prices of Blue Chip companies are less susceptible to wild swings during a bear market (the period during which securities consistently fall due to investors’ pessimism) compared to penny stocks and other investments perceived to be “riskier.” Dividend investing may also suit you if you have a large capital and do not want to “complicate” your investing strategies. Alternatively, you may consider bonds, money market funds, or certificates of deposit, which are all considered traditional income sources.

The Drawbacks of Dividend Investing

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Some professional investors are not keen on picking companies that give high dividend yields, arguing that this may jeopardize their future growth. Instead of reinvesting their profit in their business, which can be done through share buyback, new acquisitions, and the likes, they give this to their shareholders.

Another caveat of this investment approach is that companies whose stock prices have declined significantly may seem like they are doubling their dividend yields as a result. Say, a microchip manufacturer trades at $100 per share and pays an annual dividend of 5 percent, or $5. If the stock price declines by 50 percent and the management still maintains the dividend yield, there is an illusion of a 10 percent increase.

In addition, inflation can erode the purchasing power of your money, including money generated by your dividend-paying stocks. And when inflation rises, more often than not their prices also decline, which may not really be an issue if you are in for the long haul—i.e., you’re a long-term investor as opposed to being just a “trader.” Long-term investors such as Warren Buffett and Charlie Munger suggest that there is often a discord between a company’s stock price and its fundamentals, although, in the long run, the price will eventually reflect its true or intrinsic value.

Meanwhile, some money managers suggest dividend investing may not suit young investors who are into long-term holding, which generally refers to a period greater than 10 years. Conversely, high dividend stocks may suit you if you’re building your retirement portfolio, which mostly includes stable, profitable companies.

Examples of High-Paying Stocks with Strong Fundamentals

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AT&T

This telecom giant’s 5.6 percent dividend yield is not the only reason you should include it in your retirement portfolio or roster of equities. Currently, it services more than 138.8 million US subscribers, something which financial experts suggest being a near-monopolistic market position, thus ensuring its profitability for years or even decades to come.

Walmart

Unlike other retail giants swallowed by their competitors that use online platforms, Walmart has been quick to adapt to changes. According to its most recently reported quarter, its online sales grew 23 percent, a trend that is expected to further grow. The retail giant’s 2.3 percent dividend yield is just a bonus.

Southern

Another near-monopolistic stock, this utility company serves 9 million customers who are mostly in the southern part of the US. This huge market share ensures a steady stream of profit, which in turn allows the company to give regular dividend payouts that have hovered around 5 percent over the past several years.

How to Start Dividend Investing

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Now is the right time to invest to enjoy the benefits of compounding interest. While some investors have sworn by the effectiveness of timing their market through graphs and other tools used by technical analysts, the truth is that prices of stocks fluctuate from time to time even without a significant change in their underlying fundamentals (i.e., profits, revenues, cash flow, debt-to-equity ratio, etc.).

Nonetheless, savvy investors, particularly proponents of value investing and fundamental analysis, believe that in the long run, the price of a company’s stock will reflect the company’s underlying fundamentals. To reiterate, compounding interest is more potent if you hold on to a stock long term that has strong fundamentals.

In addition, dividend investing may suit you if you follow a dollar-cost averaging technique, which involves buying a fixed dollar amount of a particular investment on a regular schedule, with no regard to the price. However, some people slightly “tweak” this method by purchasing more shares when the prices are slumped and fewer shares when the prices are “expensive.”

As with any type of investing technique, always practice due diligence. If you pick this route, choose high-dividend stocks of companies that also concern themselves with capital appreciation, meaning they still allocate enough funds to grow their business and to re-invest in their future growth. Choosing profitable companies that have created an economic moat that makes it hard or even impossible for their competitors to replicate their success can also protect your investment.

Conclusion

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While it may sound counterintuitive, sound dividend investing should not only be about finding high-dividend stocks, but more importantly, choosing companies that have demonstrated strong fundamentals for many years or even decades.  

To recap, your dividend investing portfolio should consist of:

  • Companies with good historical payout ratios
  • Consistent dividend schedules
  • Sound and adaptive management strategy
  • Enviable financial position

Oftentimes the aforementioned characteristics are found in Blue Chips.

Occasionally, smaller players try to replicate the dividend yields of well-entrenched Blue Chip companies much to the detriment of their future growth. Further complicating things is their propensity to keep up with their dividend payouts since a significant or sudden decline may spook investors and cause their stock prices to fall. As such, be sure to check if a company has a steady record of producing increasing revenue and income growth, which are two indicators of healthy fundamentals.

Instead of dividend investing, some money managers suggest investing in bonds as an alternative. But historically, stocks produce higher yields on top of the increasing value of the actual securities, which of course can only be realized if you sell them to other investors.

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