The goal of every dividend investor should be generating a dependable income stream which grows over time. Dividend investors should not sacrifice the relative safety of their principal. While stock prices fluctuate and stocks do not have a guaranteed maturity price like bonds, investors should not lose track of security of principal in their quest for yield.
Investors are automatically sacrificing the income and principal of their investments by chasing yield, overpaying for the equities they purchase and failing to properly understand the business and its prospects they buy into.
The Dean of Wallstreet, Ben Graham, came up with the following definition of what an investment should achieve: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
Dividend investors should thoroughly analyze the companies they invest in, to make sure their financial foundation is sound. A sound foundation such as a plan for growth, can result in increase in earnings and dividends over time. In addition, it is imperative that dividend investors also evaluate valuation of the company whose stock they are purchasing. Even the best dividend paying companies such as Coca-Cola (KO) are not worth purchasing at any price. Investors, who purchased the stock at the highs in 1998, are still sitting at unrealized losses, and the only return they have generated has been from the rising dividend.
Investors should also avoid chasing yield without understanding the reasons behind it. For example, there has been a lot of interest about mortgage REITs such as American Capital Agency (AGNC) and Annaly Mortgage (NLY). Retirees are easily attracted to the mouthwatering yields on these investments. However after observing and discussing investors who own these securities, I have come to the conclusion that many are new to dividend investing in general, they do not understand the risks behind these companies. It is also evident that many probably have not spent the time to understand how these REITs generate these distributions. These observations are not scientific in their nature of course, and I hope I am wrong on them. The reason why I am unsure about these investments is because their distributions fluctuate greatly, as they are affected by the difference between short term borrowing close to the Fed Funds rates and subsequent investment in mortgage backed securities issued by Fannie Mae or Freddie Mac. Forecasting long-term interest rates is an exercise in futility, and so is the exercise of forecasting the spreads between interest rates on mortgage backed securities and federal funds rates.
For example, if I purchased Annaly shares at the end of 2004, I would have paid $19.62/share and expected to earn 50 cents/share every quarter. This was a very nice 10% yield. The company paid $1.04/share in 2005, which is a neat 5% yield, but almost half of what was expected to be paid. In 2006, Annaly distributed 57 cents/share, which represented another 50% decline in distributions, bringing the yield on cost to 3%. Another mREIT, Capstead Mortgage (CMO) decreased distributions from 22 cents/share at the end of 2004 to 2 cents/share for a two year periods between 2005 and 2007. This was down from a high of 53 cents/share earlier in 2004. One typical reason for investing in a high yielding stock like Annaly Mortgage (NLY) is the fact that the retiree did not save a sufficient amount of funds during their working years. As a result, these retirees need a super high yielding stock in order to pay for expenses in retirement. However, by focusing only on the highest yielding stocks, these investors are exposing themselves to wide fluctuations in distributions and stock prices. Overtime, the value of money decreases due to inflation. If our investor takes a 10% yield, and spends all of it, eventually their standard of living will decline. Add in the uncertainty as to the amount of these distributions, and the situation could become potentially very dire. That being said, mREITs could bring in some level of exposure to a dividend portfolio and might work for some investors who thoroughly understand the risks. they are taking
At the same time, investors who focused on traditional dividend growth stocks saw increases in dividend incomes, albeit they received much smaller initial distributions. However, most dividend growth stocks have stable and growing distributions, which do not fluctuate and make living off dividends much easier. In comparison Realty Income (O) traded at $25.29/share at the end of 2004 and paid monthly dividends of 10.90 cents/share, thus yielding 5.20%. The monthly dividend was never cut, and it increased to 11.60 cents/share by 2005 and 12.60 cents/share by 2006. The main difference is that the revenues for Realty Income are coming from recurring rent checks from its hundreds of properties, whereas the distributions from mREITs come from fluctuating spread between short term borrowing and the rates on mortgage backed securities.
Full Disclosure: Long O
- What are your dividend investing goals?
- Living off dividends in retirement
- Realty Income (O) – The Monthly Dividend Company
- Don’t chase High Yielding Stocks Blindly
- The number one reason why i don't chase high-yield stocks
This article was featured in the Carnival of Wealth
This is a guest post by Mike, aka The Dividend Guy. He authors The Dividend Guy Blog since 2010 and manages portfolios at Dividend Stocks Ro...
Dividend growth stocks are the gift that keeps on giving . I like the fact that most of the work in selecting good dividend growth stocks is...
I pick my own dividend paying stocks in my taxable accounts, and wouldn’t have it any other way. I know some of you have mentioned that they...
I am a fairly frugal person . An example of that is the fact that I drive a 15 year old car. I would likely keep driving this car until all ...
My retirement strategy is focused on building a dividend portfolio of high quality blue chips, which are reliable dividend payers. For my di...
This is a guest post from Keith Park, who writes about dividend investing on DivHut . Keith has been a dividend growth investor since 2007 f...
While this site is mostly about dividend investing, the topic today will be more based towards personal finance. This is because I am increa...
Mark Seed is passionate about personal finance and investing and is the blogger behind My Own Advisor . Mark is currently investing in divi...
This is a guest contribution from Liquid at Freedom 35 Blog . Liquid is an avid investor in the North American financial markets and blogs a...
Oil and gas prices are cyclical in nature. The recent downturn in energy prices that started in 2014 has pushed energy stock prices, earnin...