Why Invest in Dividend Stocks?
Investing in dividend stocks is an effective strategy for building and sustaining wealth in the long term. Dividend stocks form an integral part of a well-diversified portfolio. They help investors generate regular short-term income, long-term capital appreciation, and fight uncertainty and volatility in the markets.
As I have mentioned earlier, dividend stocks generally belong to well-established companies with sound business models and proven success. They play a vital role in the long-term success of investors and their investment portfolios. The dividend stocks have been able to generate above-average annual returns and exceed the broader market returns.
And, who can deny the power of compounding dividends! Dividend stocks also work as hedges against market volatility. I have seen companies with histories of paying dividends to be less affected by economic downturns and experience less volatility than the other players.
Investing in Companies that have a History of Paying Reliable Dividends
I always tell you that past performance is not always a reliable indicator of future performance. However, history has always supported dividend stocks. Such companies have been able to beat earnings estimates and increase dividends even during times of economic unsteadiness and instability. The companies that not only maintain their annual dividends but also increase them with time are termed as dividend aristocrats. These companies have increased their annual dividend payout for at least 25 consecutive years. There are 66 aristocrat companies in the S&P 500 but some have not been immune to the Covid-19 downturn and companies such as Ross retailer was removed from the aristocrat list.
The companies that have a history of paying dividends range from energy, telecommunications to consumer companies. Investors typically gravitate towards income stocks from blue-chip companies and the most popular stocks are in the technology space. The FAANG companies which include Facebook, Amazon, Apple, Netflix and Alphabet (formerly known as Google) are the go-to stock. These companies are among the largest in the world with a combined market capitalization of over $5 trillion and they makeup over 15% of the S&P 500. Other technology companies include Microsoft (MSFT), Tesla (TSLA) amongst others.
Financial institutions and real estate investment trust (REITs) such as Realty Income (O) and Citibank (C) are also categorized as the income stock. Income stocks can be expensive with a price tag of at least $200 per share. An alternative is to invest in different ETF’s that mirror specific sectors of the S&P 500, such as Technology Select Sector SPDR Fund (XLK), Finance Select Sector SPDR Fund (XLF) and Health Care (XLV).
Companies that also have a history of paying reliable dividends and tend to survive economies turmoil sell consumer stables. Such stocks are called defensive stocks as they are known to report stable earnings and provide consistent dividend payouts. They include utility, food and energy companies such as Johnson and Johnson (JNJ), Walmart (WMT) and Waste Management (WM).
The top performers in the US include AbbVie (ABBV) with a 5.2% dividend yield, AT&T (T) with a high dividend yield of 6.7%, and Chevron Corp. (CVX) with a dividend yield of 5.6%. Some of the rock-solid dividend aristocrats in the UK that have maintained their dividend growth during the coronavirus pandemic include British American Tobacco (GBX) with a dividend yield of 5.06%, GlaxoSmithKline (GSK) with a 4.80% dividend yield, and United Utilities Group (UU) with a dividend yield of 4.69%.
As an investor, stay away from companies that offer stock categorized as cyclical stocks and speculative stocks as they may lose value during tough economic times. Speculative stocks were the cause of the Dot.com bubble that occurred in late the 1990s and early 2000s while cyclical stocks are directly proportional to the growth or decline of the economy e.g. airline companies; there was a monumental fall in prices that Warren Buffet had to sell his shares during the COVID-19 pandemic.
Statistics For Measuring a Reliable Company’s Dividend
It is essential to evaluate the dividend stocks on various parameters before investing in them.
This will help you understand how much dividends you can expect, the safety of dividends in the future, and the reliability of the companies. The factors include:
- Dividend Yield: Dividend yield is the representation of annual dividends as a percentage of the company’s stock price. It is critical to understand that although high dividend yields are good, unreasonably high dividend yields may indicate red flags and may be illusory.
- Payout Ratio: The representation of dividend as a percentage of the company’s earnings is its payout ratio. It indicates what percentage of the earnings are paid out to shareholders compared to the retained portion. Lower payout ratios make the dividend more sustainable over a longer period.
- Dividend Coverage Ratio: The dividend coverage ratio measures how secure the dividend is based on the company’s cash flows. A dividend coverage ratio above 2 is considered healthy, while a value below 1.5 is a matter of concern.
- Dividend Growth Rate: The growth of a company’s dividend on an annual or monthly or quarterly basis is defined as the dividend growth rate. A company with a high dividend growth rate in the past indicates future dividend growth and long-term profitability.
Company and Dividend Investing Strategies
The individual strategies for investing in dividend stocks are dependent on individual goals, their risk tolerance, and financial status.
While some individuals prefer investing in established large-cap companies with stellar dividend histories, others may invest in companies with low dividend yields but with the high capability of growing their dividends consistently.
Certain investors also follow the total returns approach in dividend investing by evaluating the total capital gains and dividend payments for calculating profitability. Not to forget the short-term investors who make use of the capture strategy! They buy the stocks of companies right before their ex-dividend date and sell them just after the record date, thus taking advantage of the price movements and dividend payments, without taking long-term risks.
You may follow any dividend strategy, but remember to stay clear of high dividend yield traps. High dividend yields can be a result of the falling stock prices and may indicate that the dividends will be cut in the near future. I would also recommend you to include a margin of safety and diversify your risks by investing in companies with different risk factors.
Reliable Companies’ Actions in Tough Times
The ongoing COVID-19 pandemic has created a harsh economic situation that may lead to a global recession and it is affecting the performance of many companies. With the pandemic, some companies are beating their earnings report while other companies are filing for bankruptcy. Many companies have cut their dividends and a few others may offer high dividend yields but little prospect of dividend growth.
Companies that are forced to slash their dividend payouts will have a negative impact on the pensioners and people on the road to FIRE (Financial Independence and Retiring Early) lifestyle. However, the cuts and slashes are more or less temporary and are expected to revive as the companies recover.