Saturday , 13 July 2024

How Dividends Stocks Put More Money In Your Pocket

By sticking to companies that have the means to pay high dividend yields, you not only get the added bonus of a regular paycheque from your portfolio, but studies show that you’ll likely enjoy a higher rate of return over the long run than the market typically provides. Words: 1395

Lorimer Wilson, editor of, provides below further reformatted and edited [..] excerpts from Norm Rothery’s ( original article* for the sake of clarity and brevity to ensure a fast and easy read. Rothery goes on to say:

Dividends are typically paid out by large, mature companies which often don’t need all their cash to fund growth, so instead of reinvesting all of their profits in the corporation, they pay some of it out directly to shareholders. Perhaps because they tend to be slow-and-steady companies, these stocks have never caught the public’s imagination in the same way that junior mining ventures or supercharged tech plays have but, despite their unexciting veneer, dividend stocks may be the fastest route to riches out there for the typical investor.

Dividend Paying Stocks Result in Higher Returns
In fact, a surprisingly large fraction of the market’s real return comes from dividends. From 1975 to 2009 the MSCI World Index (a measure of the performance of stocks across the world) provided an average total return, adjusted for inflation, of 6.9% per year. Of that total, dividends accounted for 2.9 percentage points and capital gains 4.0 percentage points. In other words, dividends were nearly as important (42%) to overall returns as stock price gains – and many stocks don’t even pay them. As such, it begs the questions why an investor wouldn’t stick to stocks that pay dividends? Why not indeed!

Here’s why you might consider becoming a dividend investor too:
1. On the Canadian TSX, from 1977 through to the end of 2007
a) the highest 30% yield group of dividend paying stocks had gains of 15.9% on average each year;
b) the market as a whole provided average returns of 12.4% a year;
c) the lowest 30% yield group of stocks advanced 12.0%;
d) stocks that don’t pay dividends at all, the no-yield group, climbed a mere 5.1%.

2. On the U.S. stock exchanges it was not quite as straight forward as on the TSX and suggested that it is important not to get too greedy in one’s quest for maximum dividends. In the analysis of the U.S. markets we looked at 1997 to the end of 2009 to see how dividend stocks fared in the downturn and learned that:
a) the highest 20% yield group stocks were only the second best performers;
b) the group with the second-highest dividend yields came out on top, with annual gains of 16.8%;
c) the group with the third-highest quintile came next;
d) the fourth-highest quitile followed while
e) non-dividend paying stocks came last.

Highest Dividends Don’t Necessarily Result in Higher Returns
The very highest yielding stocks were associated with companies that had run into trouble causing their stock prices to sag dramatically forcing their yields to go up. That’s not a critical issue for dividend investors provided the dividend continues to be paid and the company eventually recovers but in stressful times – such as those seen during the recent market collapse – many firms cut their dividends or eliminate them altogether. Even worse, some companies fail entirely.

That’s why the wise dividend seeker should temper his lust for dividends and avoid bringing home the portfolio equivalent of a nasty rash. These days, if a stock yields more than 10%, alarm bells should go off. Such stocks may well have balance sheets riddled with worms and sagging income statements.

Dividend Stocks Don’t Always Act As a Buffer From a Market Crash
Speaking of risk, prior to the most recent downturn, dividend stocks had a record of holding up quite well in bear markets. James O.Shaughnessy looked at the returns of large high-yielding stocks from 1951 to the end of 2003 in his book ‘What Works on Wall Street’ and found that the worst market plunge over that period saw large stocks plummet 46.6%, but the top 50 large yielders slump only 29.0%. He also found that stocks with moderate to higher dividend yields tend to be less volatile, which means they usually provide investors with fewer sleepless nights – but not always. Regrettably, high-yield stocks didn’t provide much of a buffer during the recent collapse – they generally declined in line with the overall market.

Look For Rising Dividends
Stocks that have a habit of regularly increasing their dividends – called dividend growth stocks – fared relatively well during the market collapse in 2008/09. Sure they declined, but not by nearly as much as the market, and they rebounded nicely.

Ned Davis Research tracked the performance of dividend growth stocks in the S&P 500 from 1972 through to the end of 2009. The stocks that boosted their dividends on a year-over-year basis provided a performance advantage of a little more than two percentage points annually versus other dividend stocks. True to form, the growth group also gave investors a smoother ride with less volatility.

Dividend growth aficionados measure growth over different time frames. Some investors simply look for companies that have grown their dividends over the last year. Others are even more demanding and look for dividend growth in each of the last 5, 10, or even more years.

The Lazy Way to Dividend Riches
If you’ve settled on following a dividend oriented-strategy but you’re not quite ready to dive in and buy individual stocks, then opting for low-fee dividend ETFs or index funds is a great no-fuss way to enjoy the benefits of dividend investing.

Picking Your Own Dividend Stocks
If you’re just starting a do-it-yourself dividend journey, I strongly suggest sticking to big profitable companies. You can still make mistakes with big firms, but the mistakes are less likely to be fatal because large companies tend to be more stable than smaller firms. You should also opt for some diversification. That way, the failure of a few stocks won’t be too painful. At a bare minimum spread your bets around and buy at least 10 stocks. (Personally, I’d want to build up a portfolio of 20 or more stocks over time.) If this requirement is too hard, because you don’t have enough capital to put to work, then it might be better to start off using low-fee dividend funds.

A Dividend Portfolio to Get You Going
1. Construct a mini-portfolio based on combining stocks with generous yields and dividend growth;
2. For safety’s sake stick to larger stocks with market capitalizations (share price times shares outstanding) in excess of $1 billion.
3. Avoid stocks yielding more than 6% because they may well be too risky for conservative investors. (Keep in mind this is just a rough guide based on current market levels. I’d be willing to push the 6% cut off level higher, or lower, depending on the state of the markets.)
4. Be leery of companies that pay more in dividends than they earn – particularly if this situation persists for a long time – because such firms often cut their dividends. As a more subtle safety factor, I want companies to generate more cash flows than earnings. [Many suggest a dividend payout ratio of no more than 60%.] 5. Selected a maximum of two stocks from any particular industry group to enhance diversification by industry.
6. Consider buying roughly equal dollar amounts of each stock to form a basic dividend portfolio. More experienced investors might want to fill in industries that are currently underrepresented.

Due Diligence
Before you rush out to buy any stock, however, you should do your own due diligence. Make sure the situation hasn’t changed in some important way. Read the firm’s latest press releases and regulatory filings. Scan newspaper stories to make sure you’re aware of any recent developments.

The dividend approach isn’t likely to make you a mint overnight – and holding dividend stocks can be about as exciting as watching grass grow – but if you’ve ever gone on vacation, you’ve likely been amazed by just how much your grass can grow in a week. In the end, I can assure you, the effort will be well worth it.

* (First Published: MoneySense magazine, May 2010)

Editor’s Note:
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