Dividends can be a source of income for investors, they can also indicate growing companies whose stocks often constitute a solid investment.
And dividends have been a popular investment strategy for decades - but it can be hard to do the research, know what companies to invest in, or what products might be worthwhile.
Dividends can be a source of income for investors, they can also indicate solid, growing companies
Before getting into what dividend investing is and why it's a smart strategy, you need a platform that you can invest on it on.
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Dividends are a method of returning some of the company’s profits back to shareholders. Dividends are usually paid in cash and are generally expressed as an amount per share.
For example, a dividend payout might be Dh1 per share. Dividends can be paid at whatever interval the company’s board decides. Quarterly payments are common, especially among established companies.
Besides cash payments, stock dividends can be made. Under this scenario, shareholders will receive a designated number of shares for each share owned.
Dividends are a significant component of returns
Dividends might seem insignificant at first glance, but historically they have made up a significant part of the total return of major stock market indexes.
A study of the impact of dividends on the S&P 500, the top US index that generally represents the global market, from December of 1960 through a little over a year back showed that 82 per cent of the index’s total return was due to reinvested dividends.
Dividends might seem insignificant at first glance, but historically they have made up a significant part of the total return
Let’s say a hypothetical investor had invested let’s say the currency equivalent of Dh10,000 into the index on December 1, 1960.
Without the reinvestment of dividends, the Dh10,000 would have grown to just Dh431,397 over the roughly 50-year time horizon based solely on price appreciation.
Looking at the percentage contributions of dividends to the index’s total return by decade reinforces the importance of dividends.
(Note you cannot actually invest in an index, though there are numerous ETFs and mutual funds that attempt to replicate the performance of the index.)
Certainly, the pendulum has swung back and forth between dividends and price appreciation in importance as a source of return on the stocks in the major benchmarks over different periods of time.
For example, the decades of the 1980s and 1990s saw high levels of price appreciation in a number of stocks. The tables were turned during the 1970s and the 1940s.
Certainly, the pendulum has swung back and forth between dividends and price appreciation in importance as a source of return!
Over the time covered by this study, dividends made up over 40 per cent of the total return of the index.
Dividend Yield versus Dividend Growth
Dividend investors typically look to dividend stocks for one or both of two reasons.
For example, a stock that pays an annualized dividend of Dh2 per share with a current share price of Dh50 would have a dividend yield of 4 per cent.
If the price rose to Dh56 per share, the dividend yield would drop to roughly 3.6 per cent. The payout didn’t change, but the increase in the stock’s price would serve to lower the current dividend yield.
The annualized dividend payout that is generally used is the latest quarterly payout times four. The dividend yield will generally change daily with the price movements of the stock.
A high dividend yield can be a function of both an increased payout and/or a decline in the stock’s price.
In reaching for stocks with high yields, it’s important for investors to look beyond the dividend yield to ensure they understand why the yield is high and if the dividend payout is sustainable.
One sector whose stock often has a high yield is utilities and telecoms. They have stable cash flows and often have a near monopoly in their region.
One sector whose stock often has a high yield is utilities and telecoms.
While the share price may not move much unless there is some sort of abnormal event, the dividend payouts are often pretty stable. This isn’t the case with all stocks with a high dividend yield.
Companies that do this are generally well-managed and financially sound.
The ability to sustain and increase the dividend payout each year is a sign that the company is growing its bottom line and is generating solid cash flows.
Whether you invest in companies with a high yield or those with growing payouts, dividend investing can be a solid way to generate a stream of income from your portfolio.
This might be a source of passive income as you approach retirement, for example.
Note that none of these are mutually exclusive, investors can mix and match any of these into their overall investing strategy.
Individual Dividend-Paying Stocks
Investors can buy individual dividend-paying stocks. Whether or not this is a good strategy will depend upon each investor’s individual situation and their investment strategy.
A key consideration is whether or not you will be able to build a diversified portfolio of individual stocks going this route.
There are many investors who look to build a stream of income by building a portfolio of individual dividend-paying names.
A caution to keep in mind is that even dividend-paying stocks are susceptible to movements in the stock market, though many are less volatile than the market as a whole.
Mutual Funds and ETFs
There are a number of mutual funds and ETFs that focus on dividend stocks either from a dividend growth perspective or a yield focus.
The companies held in the fund usually offer higher-than-average dividend yields. There is also an ETF version of the fund. The recent yield of the fund was 3.3 per cent versus a yield of under 2.0 per cent for the S&P 500 index.
Vanguard Dividend Appreciation ETF (ticker VIG) includes companies that have increased their dividend payout annually for a minimum of 10 consecutive years.
This fund is focused on dividend growth versus yield growth. The fund is also available as a mutual fund as well. There are several other funds and ETFs that focus on the dividend stocks in some form.
There are a number of mutual funds and ETFs that focus on dividend stocks either from a dividend growth perspective or a yield focus.
So, what are the key takeaways?
Dividends are an important component of return for stocks. Companies that can continue to pay dividends annually can be excellent investments, especially those that are able to consistently increase their payout levels.
It is important for investors to understand the underlying financials of any stock they might be considering, helping ensure that the company is a solid investment for them.
Dividends are an important component of return for stocks. Be sure the dividend is sustainable.
Be sure the dividend is sustainable. It’s also important to realize that even dividend-paying stocks can get hit when the stock market corrects itself.
Mutual funds and ETFs that focus on dividends can be a good alternative. Be sure that you understand the fund’s objectives and its expenses. Make sure that these objectives are consistent with your investing goals.
