Wednesday, June 23, 2010

Dividend Investing Myths

Many investors ignore dividend investing, because they associate them with boring unexciting investments which are destined to fall into oblivion.

Some investors believe that rather than wait for a whole year to collect a 3%-4% dividend, you could make 3-4 % per day in the market trading volatile technology stocks. The fact of the matter is that few if any investors could accurately forecast stock market moves in order to profit from large daily swings in some of the most volatile stocks in the market today. Dividend payments on the other hand are much less volatile than stock prices, which is what makes them ideal for investors who plan to live off their investments. The stability of the payments makes them a reliable source of income in virtually any market, without having to sell a portion of one’s portfolios and exposing yourself to market fluctuations.

Companies such as Clorox (CLX) are a good example of dividend payers which have raised distributions consistently, and which have a stable business model to support future dividend raises. (analysis) The company is currently valued attractively at a P/E of 15.30 and yielding 3.40%. It has managed to not only pay out decent amounts of its profits as distributions, but also to grow the business overtime.

Most of the components of the S&P Dividend Aristocrats index and the Dividend Achievers Index are a good starting point for dividend investors, as they include companies which have long histories of uninterrupted dividend growth.

Other investors believe that you need to start with a large portfolio size in order to generate any decent income off your investments. The fact is that you don’t need a large portfolio to benefit from dividend investing – you could start small and work your way to your desired level of income over time. By starting small, investors could lose small amounts in the process of fine-tuning their income strategies until they perfect them well enough to fit their personal investment goals and risk tolerances. Investors who start large and make mistakes have much more to lose in the process. An investor without a proper plan who placed all of their hard earned cash in a concentrated portfolio of financial stocks such as Citigroup (C), Bank of America (BAC) and American Capital Strategies (ACAS), would have experienced large losses of capital and income. Had this investor purchased only a small starter position in each of these companies, they would have had much more time to reassess the situation and diversify their holdings accordingly. There’s nothing wrong with starting out small, by dollar cost averaging your way into at least 30 stocks from different sectors and reinvesting dividends selectively. Through the power of compounding those portfolios would most probably grow over time to a large enough nest egg.

Another myth is that dividend investors mindlessly reinvest dividends, through bull markets and bear markets. While many drip (dividend reinvestment plan) investors tend to purchase stocks and reinvest dividends, many investors actually reinvest very selectively. They allocate the dividend cash received very carefully into the same stock or in stocks which have proper valuations and adequate coverage of its distributions, as well as having the solid fundamental framework to support increasing payments to the shareholder over time. Reinvesting dividends when stock prices are trading at a historic price/earnings ratio and record low yields is not a good idea, especially when the cash could be deployed in other companies which are offering better valuations. One example of a company which currently offers attractive valuations is Abbott Labs (ABT), which trades ata P/E of 14.30 and yields 3.60%. The company has raised distributions for 38 years in a row. (analysis).

Many retirees are constantly being sold on the idea that bonds are the best way to generate income in retirement. While the payout from fixed income securities, particularly US Treasury obligations is very stable, the main negative is the fact that it loses its purchasing value over time due to inflation. While TIPS (TIP) could be an exception to that, many investors might feel that the consumer price index adjustments in the TIPS’ coupon payments and principals do not adjust for the particular investors’ basket of goods and services used. Common stocks on the other hand could offer a better source of inflation adjusted income, despite the fact that they have certain amounts of risk involved with them. Dividend growth stocks should be of particular interest to investors, as most of these fine companies represent firms which have a product or service which investors need, which allows the company to charge higher prices over time. This ensures rising profits, which in turn trickles down to increased dividends. A bond which yields 4% today would likely yield 4% for you 30 years from now. On the other hand companies with strong competitive advantages, whose products consumers use on a daily basis such as retailer Wal-Mart (WMT), could pay a much higher yield on cost on your investment 3 decades from now. The number one retailer in the US has turned its price advantage over competitors into consistent growth in the US and internationally, which has fueled strong earnings and dividend growth. Check my analysis of the stock.

In addition to that, investors could purchase stocks which mimic their actual expenditures, and therefore have their dividends pay for these expenses. For example an investor who has a phone bill for $50/month, needs to invest almost $9,000in AT&T (T) or Verizon (VZ) in order to generate enough income to cover that charge.

Other investors believe that you need a high dividend yielder in order to generate a decent return on your investment. Actually you don’t need to select the company with the highest dividend yield in order to be successful at dividend investing. In fact companies which have a track record of consistent dividend increases for over ten years could generate higher yields on cost in the future which could surpass even the highest yielding stock of today. Those companies have achieved a perfect balance between the need to fund the growth in their business and the need to return cash to shareholders. This is a powerful combination which ensures that investors could not only have a solid foundation for future distribution growth but also the opportunity to enjoy solid capital gains as well. Consumer giant Johnson & Johnson (JNJ), which has raised dividends for 48 years in a row is a prime example of such a company. The firm is attractively valued at the moment, trading at a P/E of 12.40, yielding 3.60%, and having a 10 year average annual dividend growth rate of 13.30%.

The truth of the matter is that dividend stocks are a superior way to not only enjoy the market upside, but to also receive a positive return during bear market declines. Dividend payments could also generate much needed capital to investors to deploy into the market, thus further compounding investor returns over time.

Full Disclosure: Long ABT, CLX, JNJ, T, WMT

Relevant Articles:

- Why Dividend Growth Stocks Rock?
- Dividend Investors are getting paid for waiting
- Dividend Investing Works in All Markets
- Living off dividends in retirement

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