Dividend Investing – How It Works

A steady, dependable dividend stream provides a nice boost to a portfolio’s overall return.  Dividend investing is a popular strategy for long-term investors.
 
The goal of dividend investing is to generate a steady stream of income through dividend payouts. A secondary focus of dividend investing is to capture financial growth through appreciation in stock prices or unit prices. 
 
Dividend and dividend growth investing is an attractive investment strategy, particularly for long-term investors, and for those who want to balance risk with the necessities of generating an income stream.

Benefits of Dividend Investing 

Dividends are usually paid whether the broad market is up or down. Subsequently, dividend dependability is a big reason to consider dividends when buying stock. 
 
A dividend stream provides a natural hedge against inflation and also accelerates the payback on investment.  
 
Dividends offer tax advantages. Unlike other forms of income, such as interest on fixed-income investments. There are two classes: “Qualified” dividends, taxed at the lower, long-term capital gains rate, and “unqualified” or “ordinary” dividends, which are taxed as regular income. 

Most dividends paid by U.S. corporations are qualified dividends. This means income from dividends is taxed at the long-term capital gains rate. This applies when investors own the stock for 60 days (in most cases).

Dividend-paying stocks tend to be less volatile than non-dividend-paying stocks.  

A reinvested dividend stream takes advantage of the power of compounding and can help build wealth over time.

Challenges of Dividend Investing

For dividend investors, keeping track of dividend announcements and corporate actions that occur during the reporting season can become a monumental task. 
 
The investor has to check the share registry or the stock transfer agent for the amount declared and paid. The investor must then cross verify with the bank account nominated to receive these dividend payouts. Keeping track of data between the broker and the share registry or stock transfer agent becomes tedious. Investors tracking dividends are prone to dealing with inaccuracies or incomplete data. 

Stock or unit prices tend to fall after the ex-dividend date because the valuation of the underlying company or portfolio will decrease when dividends are paid out. The adjustment may not be easily observed during the daily price fluctuations of a typical stock, but the adjustment does happen. This adjustment is much more obvious when a company pays a one-time dividend. 
 
Companies never guarantee their dividends, and they can suspend or cut payments. In addition, larger, more mature companies more commonly pay out dividends. Whereas, smaller, less established companies are more likely to reinvest their earnings. 

Dividend Investing in Long-Term Portfolios

For many investors, regular dividend income is a reliable way to grow a nest egg. Dividend stocks can provide a source of cash flow when it’s time to turn lifelong investments into a retirement paycheck. About 80% of S&P 500 stocks pay a dividend. And while the current dividend yield is less than 2.0%, it’s still much higher than the average savings account or Treasury Bond rates. 

If you invested in an S&P 500 index fund in January 2000 and held the investment until September 2020, your average annualized return based on price gains alone would have been 4.2%, for a cumulative return of 136%. But if you’d reinvested all dividend payments back in the fund over the same period, your annualized return would have been 6.2%, for a cumulative return of 247%. The simple act of reinvesting dividends would have nearly doubled your gains. 

Metrics to Track

What metrics should a Dividend Investor focus on when identifying new opportunities? 

1. Dividend Yield

This is the ratio of dividends to stock price. The metric tells you how much income you might get from the stock(s) you own. Dividend yield can increase if either the dividend payout increases or if the stock price decreases. That being said, investors should be wary of a dividend yield trap, where a price decrease is due to a fundamental issue with the underlying business. Dividend yield is calculated as follows: 
 
Annual Dividend per Share / Current Stock Price = Dividend Yield 

2. Dividend Payout Ratio 

This metric compares the portion of net income paid out as a dividend. Unlike dividend yield, the dividend payout ratio is not influenced by stock price. 
 
Total Dividends / Net Income = Payout Ratio 

How to Pursue Dividend Investing 

There are multiple strategies to implement when looking for dividend stocks.  

1. Mature Companies with High Dividend Yields

The focus here should be on established companies with a lot of cash flow that pay dividends. These investments make sense for an investor that is looking to generate income right away. Keep in mind, however, that high yields aren’t everything. The companies may not see as much growth in stock value as other companies with lower dividend yields. 

2. High Dividend Growth 

Investors with a longer time horizon can focus on buying stock in companies that are growing quickly but currently pay below average dividends. As the company grows, and its business matures, the dividend yield should rise gradually. 

3. Dividend Capture

With this strategy, investors buy stocks before the dividend is paid out. Then, they sell the stock after the dividend has been paid out. It is a timing-oriented strategy; the investor simply purchases the stock prior to the ex-dividend date and then sells it either on the ex-dividend date or at some point afterward. Because the investor owned the stock on the ex-date, the dividend will automatically be paid regardless of whether the investor still owns the stock by the time it is constructively received. The high turnover generated by this strategy makes it popular with day traders and active money managers. 

We will soon be releasing our part 2 of the Dividend Investing strategy. You can find this under the Investing section under Personal Finance.