Wednesday, July 24, 2013

Frequently Asked Questions (FAQ) About Dividend Investing

I have highlighted below several frequently asked questions about dividend investing. This is not an all inclusive list, but more of a running total of questions I am usually asked about dividend investing, dividend growth stocks and my strategy. The answers pertain to my investing, strategy and experience, and I have tried to respond to the best of my knowledge and intentions. As I get new recurring questions asked, I would add them to this list.

Why should you focus on dividends?

A company that pays dividends is less risky than a company that has never paid a dividend. A company that pays dividends pays with actual cash, which cannot be easily manipulated like earnings. Dividends are a more stable part of total returns, and are always positive, which is what makes them ideal for retirees who want to live off their nest egg. Paying a dividend imposes discipline on management, that makes them evaluate the cash flow impacts of new projects and make them only focus on the best ideas. This dividend payment makes management less likely to engage in empire building, and less likely to simply hoard cash or mindlessly expand/acquire companies which are not accretive to returns. Few US managements are willing to cut a dividend – doing so sends signals that the company is weak financially.

What are you looking for in a dividend stock?

In my entry criteria, I focus on companies which manage to increase dividends over time because they have growing earnings, trade at a P/E below 20, yield above 2.50% and have a dividend payout ratio below 60%. I have violated some of those rules before, but I have also focused on only buying companies that can increase earnings and not paying more than 20 times earnings. I also do qualitative analysis in order to understand the business of the company, whether it has any moat, competitive advantages, strong brands, pricing power and the ability to increase earnings over time.

How to you handle dividend payments?

As an investor in the accumulation phase, I re-invest dividends selectively. This means that I accumulate cash dividends all the way up to $1,000 or $2,000, and then purchase shares in a company I believe to be attractively valued. I am not a fan of automatic dividend reinvestment, unless of course your portfolio is so tiny that the transaction costs would negate any benefit of investing in the cheapest stocks.  I target 6%– 7% in annual dividend growth, coupled with a 3% - 4% yield on my portfolio, for a total of 10% in dividend income increase every year. Once I retire and live off my portfolio, I would spend all of the income, and would rely on organic dividend growth to keep up with inflation.

When would you sell a dividend stock?

I usually sell after a dividend cut, after a company I own is acquired, or if it becomes too overvalued for the growth I expect out of it. For example in 2012, Con Edison (ED) traded at a yield of 4% despite the fact that it was growing distributions at less than 1%/year for the past 16 years. In addition, shares of Universal Health Realty Income (UHT) were similarly overvalued relative to their dividend growth.  I try to buy great stocks that would do great things in increasing earnings, dividends and stock prices, but sometimes life happens and either growth slows down, the stock gets massively overvalued or the financial conditions deteriorate. My expectation is to never sell when I buy (otherwise, why would I buy in the first place), although I monitor frequently my portfolio.  I expect that my best ideas would go up over 1000% in my lifetime, and I would keep holding on to them until I pass them over to my heirs.  These would be the stocks that would generate large portions of my returns. Selling a stock that will go up by 1000% in 20 – 30 years for a small gain without letting it ride out to full potential will likely cost a lot, and could mean you lose money in dividend investing rather than make any.

Don't only companies that do not grow pay dividends? Companies that cannot find anything better to invest money in tend to pay dividends.

It is true that companies like Google (GOOG) have never paid a dividend; nor did Apple (AAPL) pay a dividend between 1997 – 2011, when its stock rose a lot.  However, most companies that do not pay dividends do so because they cannot afford to because they have deteriorating financials or need all of the money to be reinvested in the business, as they are not generating excess cash flows.  If you focus on companies that do not pay a dividend, chances are that few will be the Googles or Berkshire Hathaway’s (BRK.B) of the world, but most might be the Worldcom’s, General Motors, Eastman Kodak’s etc.

Actually, some of the best performing stocks have managed not only to grow business but also pay a rising dividend over time. Such companies include Wal-Mart (WMT), McDonald’s (MCD) and Coca-Cola (KO). My goal is identifying these companies that not only increase earnings and dividends, but also trade at a reasonable valuation. That being said, not all companies that pay dividends are good investments.  Please check above on the factors I look for in a stock.

But Warren Buffett doesn’t believe in paying dividends – Berkshire has not paid a dividend since 1967

Berkshire Hathaway has not paid dividends since 1960’s. However, Buffett does invest in businesses and companies that pay dividends, and he uses these cash flows to invest in other cash generating stocks and businesses. This is similar to what dividend investors do – buy stocks and then reinvest them in other attractively valued stocks if in the accumulation stage. If you are retired, then chances are you still reinvest your excess cash in more dividend stocks. While Buffett is an excellent capital allocator, few other companies can match his expertise. Most companies that invest excess earnings into other relevant businesses or unrelated industries have a poor track record. The sole fact that there is just one Berkshire Hathaway but over 100 dividend champions speaks volumes.

But what about total returns?

As I mentioned above, I focus on companies that I believe will increase earnings per share over time. This is the driver behind dividend growth over time. A company with rising earnings per share would likely increase in price over time. As a result, I do hope that the companies I buy will be more valuable over time, and would generate total returns. However, I focus on dividends because they are a more reliable portion of total return than capital gains for living off your nest egg.

What about taxes?

Qualified dividends derived from US corporations are taxed at a maximum tax rate of 23.80% to US residents. This is much lower than tax rates on interest income, which is taxed much higher at the ordinary income tax rates (except muni-bonds). Unfortunately, if you income is less than $400,000 for single or $450,000 for joint returns, you would pay anywhere from 0% to 15%.

Taxation varies for REITs and MLPs, and is unique to the entity paying them and the personal situation of the individual receiving distributions from these entities. Not investing in dividend stocks and equities in general because they could result in tax liabilities is not a smart strategy to follow. It is possible for US investors to defer/avoid paying taxes on investment income if it is placed in tax-advantaged accounts such as 401(k), IRA, ROTH IRA, SEP IRA etc. If you are a US resident investing in foreign corporations, you might end up paying withholding taxes on dividends received, even if you held them in a tax-advantaged account however.

But is a 2% yield sufficient to protect you against inflation?

I focus on companies which have yields that look low today, but which I believe would increase dividends above the rate of inflation. If this dividend growth is fueled by earnings growth, chances are that stock price will increase as well.  For example, let’s examine a situation where you bought a dividend growth stock that trades at $100/share, earns $5/share and pays a $2 annual dividend. If this company is able to grow earnings and distributions by 7%/year over the next decade, and inflation grows at 3%/year, you will be ahead of inflation. That means that in year two, the company would earn $5.35/share, pay $2.14/share and likely trade around $107/share. In order to maintain purchasing power in year two as year one, the stock would have had to trade at $103/share and would have had to pay $2.06/share.  If you add in that excess over inflation, it can lead to more wealth over time. Since 1920, dividends on the Dow Jones Industrials have increased by 5%/year, which was 2% higher than inflation. As a result, I find dividend growth stocks to be the perfect source of inflation proof source of income.

But I would need $500,000/$1,000,000 invested in dividend paying stocks to make a meaningful amount of dividends to live off?

In order to live off your nest egg, you need to build a nest egg first. I focus on building income, rather than a set amount to invest in. However, if you are just getting started and need $40,000 in annual income, you would likely need to invest about $1 million in dividend paying stocks. However, if you asked a traditional portfolio planner/financial adviser, they would have advised you to have $1 million in your portfolio and follow the traditional 4% rule. As a result, the requirement to have a nest egg to live off of with dividend stocks is no different than what you would need in a traditional index funds/bond fund allocations. The goal is to start as early as possible, in order to get time and compounding on your side. Dividend investing is not a get rich quick scheme.

But doesn’t dividend investing take too much time?

Dividend growth investing does require a time commitment.  The time is spent scanning the market for opportunities, analyzing companies through reading annual reports, analyst reports, and filings. The time is also spent reviewing your portfolio regularly as well. However, once you have a certain level of understanding behind the companies you own, updating that knowledge should not take as much time. In general, you can spend about 10 hours/week easily on average, with a lot of it spent in the February – April period when most annual reports are sent out. If you are unable to dedicate time to managing your individual portfolio, you can outsource it by focusing on stock or bond funds. However, depending on your choices, you might end up paying a steep price every year for this privilege.

What about bonds/real estate/gold?

I believe that a portfolio should be well-rounded with different asset classes that do well under various conditions. I would like to have a 20% - 25% allocation to US treasuries when I retire, which would protect my nest egg for a Depression like scenario like the US experienced in 1929 – 1933 or Japan between 1989 – 2013.

I am not capable of managing real estate myself, but instead focus on Real Estate Investment Trusts.
I do not own gold/silver except for a few coins for numismatic purposes ( I also used to collect stamps at  one point). I do not see much value in it in a typical investment portfolio. I like to own assets that have a productive capacity such as stocks or real estate for example. However, gold has been the asset to own if you were part of a minority that is being persecuted and you need to leave (Jewish community in Poland in 1939).

What are your favorite resources to research dividend investing?

I read annual reports, where I obtain most of my data. I use the Securities and Exchange commission website for this at SEC.gov. I also use Yahoo! Finance to keep tabs on my many holdings, in a personalized watch list. I also have a few favorite authors on dividend investing:

Why spend all that time on dividend investing, when no one can outperform index funds?

As a dividend investor my goal is not to outperform the S&P 500, although I do compare increases in my dividend income to increases in S&P 500 dividends. The S&P 500 is a list of stocks which is arbitrarily selected by a committee in Standard & Poor’s according to who knows what criteria – it is not even a list of the 500 largest companies in the US.  The 40 largest companies in the index account for almost half of its weighting. The committee in charge of maintaining S&P 500 included Berkshire Hathaway only a few years ago. During height of the dot-come bubble in 1999 – 2000 they added a lot of so called "new economy stocks", right before they crashed and burned. My goal is to generate a growing stream of dividend income every year, and to achieve that I focus on companies which I believe are undervalued today, have solid competitive advantages that I understand, and will likely increase earnings and dividends over time. I have a friend who owns an auto repair shop.  I never ask him how his business is doing relative to the S&P 500, or else he would think that some of the screws in my head might be failing.

Incidentally however, dividend growth stocks since 1972, dividend champions since 2007 and dividend achievers since 1996 have outperformed the S&P 500 or very closely followed it.

Readers of Dividend Growth Investor website, I would appreciate your feedback on Frequently Asked Questions. If you have input on the existing answers to these questions, or if you could think of any additional ones, I would be more than happy to hear from you here or in my email address. My e-mail is dividendgrowthinvestor at gmail dot com.

Note: This article was included in the Carnival of Wealth, Hunter Mahan Is Too Rich Edition

10 comments:

  1. Great answers to similar questions I receive as well. I am in the accumulation phase and so I currently DRIP each stock I own, however I expect in the next 2-3 years I will be more able to start accumulating dividends and reinvest selectively. Great blog, I enjoy reading and learning from it.

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  2. Hello DGI,

    This is my first comment on your blog, which I've enjoyed for some months now.

    I'm a professional financial adviser, and CFA charterholder, with a focus on dividend growth stocks. It's tough being a proponent of the strategy in my line of work, as I am surrounded by much older colleagues who prefer to speculate on stock price movements (and often not in the long term, either). So, I'm grateful to have stumbled upon your blog and for the fact that you update so often with meaningful entries that speak to common sense.

    I have a question for you: where do you look up the dividend growth rate for the S&P 500 index? I have tried to find the data on Standard & Poor's website to no avail so far. I know it might sound strange that a professional is asking this question, but as you can probably imagine, my default benchmark at work is unfortunately the S&P 500 Total Return and not something so pertinent as the S&P 500's dividend growth rate. Any help you can give is much appreciated.

    Thanks, and speak soon.

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  3. Robert,

    Thanks for your comment. I hope you are able to accumulate more dividends, so that you can reinvest more selectively. At this stage though, a DRIP might be best.

    Hamsterius,

    Most individuals I have met in real life are either scared about the stock market, or they are actively speculating in stocks. It is difficult to find good investors in real life.

    For SP500, you can get data from 1988 from the S&P website. http://www.spindices.com/indices/equity/sp-500

    Just go to "additional info" button. They do seem to have changed the site look since I went there last time, so I might be wrong.

    You can also use Prof Schiller's data:

    http://www.econ.yale.edu/~shiller/data/chapt26.xls

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  4. DGI this was a great "to sum it all up" type of post that will help a lot of your readers. I wish I had this last year lol, but it will help me tons. Thanks!

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  5. Hi DGI,

    I've been searching the internet for an article that is dividend investing vs. index investing but haven't found an adequate piece that can put numbers side-by-side to see which is better for someone who is in their 20s. I have the understanding that indexing *may* be better than dividend growth in a taxable accounts, at least, due to the yearly taxation on dividends as opposed to the LTCG rates on index funds.

    I would imagine in this case that it'd be more tax efficient to index while accumulating a nest egg, then transition to dividend investing while approaching retirement. Perhaps these two approaches could co-exist?

    Do you have any articles in mind that would put my mind at ease? I have been frequently reading Bogleheads' forum so that's all I pretty much have to learn from thus far.

    Also, how do you feel about dividend-focused ETFs for someone just starting out? I have a small investment (for early retirement) in DVY (iShares) that has a 0.40% ER but no transaction fee through Fidelity. I would plan on using that until accumulating enough assets to manually diversify, as well as investing direct through the individual companies (ie: PG).

    Thanks.

    ReplyDelete
  6. DGI,

    Wow! Great stuff. From one passionate blogger/dividend investor to another, this was one of your finest articles yet. And that's saying a lot, because you've published a lot of them.

    Thanks for the kind mention. I'm humbled and honored to be among your resources. Thanks so much.

    This is a consummate piece. Really great stuff.

    Best wishes!

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  7. Investing Early & Dividend Mantra,

    Thank you so much for stopping by and leaving a comment!

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  8. Mike M,

    Thanks for the comment.

    I have written before on index funds:

    http://www.dividendgrowthinvestor.com/2010/06/6-dividend-stocks-which-beat-index.html

    I also reference S&P 500 index in this article:

    http://www.dividendgrowthinvestor.com/2013/06/are-performance-comparisons-to-s-500.html

    In the second one, I discuss how with index funds you get to pay taxes on dividends paid, and also on the turnover in the holdings there - LTCG and STCG.

    Please let me know if these articles answer most of your questions.

    I think index funds would work for you if you do not have the time to focus on investments or if the only investments you can afford to make are in a company 401K for example. I own index funds in my 401K, because I do not have any other options.

    My goal is to live off my portfolio - dividend growth stocks provide the income to achieve that. I live and breathe my portfolio, so I don't mind spending 10- 15 hours/week on it. This is because my dividend machine will help provide me with income to finance my retirement. I also expect total returns to at least match S&P 500 over time.

    As for dividend ETF's, they could work for you, if you can only buy through a mutual fund service or not a lot of money yet to "break even" from a commission standpoint. If you have the money in a taxable brokerage account or some IRA, i am going to be honest that i don't like dividend ETFs. Check this here:

    http://www.dividendgrowthinvestor.com/2010/07/dividend-etf-or-dividend-stocks.html

    http://www.dividendgrowthinvestor.com/2008/11/dividend-etfs-for-busy-investors.html

    http://www.dividendgrowthinvestor.com/2008/01/are-dividend-etfs-for-you.html

    Thanks for reading!

    Dividend Growth Investor

    ReplyDelete
  9. DGI,

    Thank you very much for the links. They were quite helpful. I totally agree about ETFs. I only plan on using DVY until reaching enough money to manually diversify. Since I'm constantly checking my investments, the issue of having time to conduct weekly/monthly DD won't be an issue.

    I wish I thought more seriously about dividend stocks before going all-in on index funds but since I'm still in my 20s, there's plenty of time to start switching at least a portion of my investments.

    Forgive me for not reading all of your posts (working on it!), but do you have an ESPP? I figure that'll be a powerful tool to obtaining more capital by taking advantage of a company's discount.

    In recent past, I invested directly through PG so I'll get that back up and running again. It's nice being able to put money and only have to deal with transaction costs when selling.

    Thanks again for the help and I look forward to reading the rest of your posts!

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  10. Mike,

    Thanks for reading. You can actually find information either by looking at the archive,http://www.dividendgrowthinvestor.com/2013/03/complete-list-of-articles-on-dividend.html

    or if you use the toolbar at the top left, and enter search criteria.

    I do have ESPP, but I sometimes find it to be more of a hassle than a benefit. At least whenever I find companies to add, I usually have some money locked in ESPP for a few more months.

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