Why I Love Dividend-Paying Companies
Dividends are the lost souls of the investing world. They aren’t glamorous. For several companies, dividends only pay out a few cents every quarter and represent companies that are no longer considered growth companies. Price appreciation for these stocks are limited, or so the thinking goes.
But, here’s a twist. Did you know that during World War I the New York Stock Exchange was halted during the initial stages of the war? This halt lasted for over three months. It’s the longest stretch of the NYSE closing. Here are two questions for you:
- How much price appreciation did stocks on the NYSE experience during that down period?
- How many dividends were paid during that same period?
If you answered “none” for the first question and “all of them” for the second question, give yourself a prize. In other words, stocks did not appreciate, but all dividend-paying stocks still paid the dividends due for the period.
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How Dividends Create Wealth
One of the greatest means of wealth generation is to discover sources of passive income. These sources will make money for you whether you are on a trip or you are home. That’s the point of passive income. You don’t have to work for them. They just keep on generating income each period for the agreement.
Dividends are a source of passive income. It takes some time to build a substantial portfolio of dividend-paying stocks. But, once you do, you simply sit back and collect your dividend checks. These can add up to significant sums of money. For many who are dedicated to this, they can replace incomes at work, and then some!
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Why Don't More People Buy Dividend Stocks?
People have this notion that dividend stocks offer less appreciation for a stock than a stock that does not pay dividends. Investors have been taught there is a difference between growth stocks and dividend-paying stocks. The growth stocks have the potential to continue their upward ascent, while the dividend stocks will be relatively even keel. However, with reinvesting the dividends, over time dividend stocks could outperform their non-dividend counterparts.
Remember, during market downturns, dividend stocks continue to pay their dividends. This buffers the downturn in the market. A growth stock could take months or even years to recover. Many impatient investors bail after a few months and take a loss in the process.
As for growth stocks heading into the stratosphere, the average investor is not savvy enough to pick the right stocks that will exhibit these traits. Most of these investors will be lucky if they see any gains in the stocks they choose. On the other hand, if these average investors were to choose dividend stocks and hang onto them for long periods, even the weaker companies would continue to pay their dividends.
Take It Slow
Don’t rush out and put all your money into dividend-paying stocks, yet. Not all of them are created equal. Investors make the mistake of finding the highest yielding dividend payers and then are disappointed when those stocks don’t pan out.
When considering dividend stocks, you should build up your wealth slowly. Also, diversify your holdings in case a few of the companies don’t pan out. Sometimes, companies will use dividends to lure investors into a false sense of security. In fact, a jump in the dividend payout can be a warning sign to behold. In general, you’ll want to find steady payers that increase their dividends over time.
Don’t Focus Only on the Dividend
As mentioned, a company can use dividends to trick investors into thinking they are a good company. If you only look at the dividends when choosing companies, you’ll likely get blindsided when several of these companies go bust. It happens often. Therefore, you still need to find dividend payers whose financials are solid. There are no shortcuts here. Do your homework, no matter what!
Reinvesting Your Dividends
While it is tempting to buy something nice with your dividend payouts, you’ll be serving your needs better when you reinvest your dividends. There’s a caveat with this, however. If you reinvest using your broker, you will be charged commissions on this reinvestment. This used to be a bigger deal when commissions were hundreds of dollars per transaction. Today, many brokers charge such low commissions that it’s not going to break the bank.
You need to gauge the amount you receive compared to the amount charged by your broker. If your broker charges commissions of $4.95 and your dividend check is $4.95, it doesn’t make much sense to reinvest the dividend at that point. Yes, it will likely pay off later as you accumulate more stock. But, it’s a trade off.
An alternative is to wait several payout periods and reinvest more of shares. The commissions should still be $4.95 (or whatever your broker charges), but you’ll get more shares as a result.
Dividend Reinvestments Plans (DRIPs)
Perhaps a better approach is to buy a dividend-paying stock directly from a company. This concept is known as a Dividend Reinvestment Plan or DRIP. Many larger companies support this concept. Essentially, when you get a dividend payment, it is automatically reinvested with the purchase of more shares. In most cases (perhaps all?) there are no commissions when using this method. The downside is the transactions are outside of your regular brokerage account. If you are interested in this option, call companies on your consideration list to ask if they support it.
Taxes
This isn’t meant to be financial advice, and I am not an accountant. However, dividends are taxable income in most cases. It is possible to invest in a retirement account. But, make sure you work with a financial professional to figure out the best ways to structure your dividend investing. There are too many rules and loopholes to cover it correctly in an article. The takeaway is that taxes matter so consider that when making an investment.
Choosing Dividend Stocks
People go right for the yield when choosing a dividend stock. You can understand the motivation behind doing this. After all, who wouldn’t want the highest-paying dividends in their portfolio? But, the concept is flawed, and I covered one of the main reasons why.
Choose companies that have good economics and a superior management team. Choose companies who have competitive advantages. Companies paying dividends should have little to no debt. Otherwise, when they run into trouble, they will reduce or eliminate the dividend. Another factor is to find companies who have a solid record of increasing gradually the dividend amount. Erratic histories are a red flag. It's a sign that management doesn't have a good plan or are playing games with finances. Either way, move on to better companies.
Why Do Companies Pay Dividends?
When a responsible company has nothing else to do with the money it makes, the right action for it to take is to return the money to shareholders. This return is often in the form of a dividend payment. Notice I used the term “responsible.”
Not every company acts for the benefit of its shareholders. Some unsavory companies will try to find creative ways to put the money to use that will somehow enrich a few players. They will engineer fake sales, or they will use the excess money to pump up revenues. Another option is to buy back shares. Investors seem to love this. However, it is usually a smoke-and-mirror technique that serves the upper-echelon in the company.
These reasons illustrate the need to perform due diligence when selecting dividend-paying companies. While this article isn’t meant to advise you on how to select the right stocks, you should consider strong companies that have been paying dividends consistently. You should also try to find companies that have raised their dividends during the payout periods. Big jumps in payouts should always be investigated. The payouts should be in line with the company’s payout history, or management should have a great reason why they increased a payout substantially.
Capital Appreciation
It is possible for the stocks of dividend-paying companies to appreciate in value. It happens all the time with great companies. All equal, these companies provide value to their customers which keeps the customers returning. While this should not be the focus when looking for income generation, it is a bonus. Of course, that appreciation doesn’t mean much if your plan is to hang onto the stock. But, if you ever decide to sell, it will be a great boost to your returns.
Summary
Hopefully, you have learned about how dividends can be a great way to boost your income. It can help you weather storms in the financial markets, and it can grow your ownership in companies over time where you’ll receive larger checks in your account. You will be amazed at how quickly your income grows.
