When most people think of investing, they immediately think of the gains. They envision themselves as the savvy investor that buys Amazon ( AMZN) or Google ( GOOGL) for pennies on the dollar and watches it balloon into a multi-trillion-dollar company. Or the day trader keenly weaving in and out of positions, always buying low and selling high. The concept is certainly seductive, but as an investor it’s essential to recognize that for every Amazon there is also an Akamai Technologies ( AKAM).
For a little historical context, Akamai IPO’d on November 1 st, 1999 for $26 per share on NASDAQ. On its first day of trading the stock price exploded and closed at $145.19 per share; a gain of over 400% in a single day! AKAM remains a profitable, respected name today, but had you bought at the high you’d still be underwater as the stock now trades for ~$100; 20 years later your total return would have been -31.12%!
Building wealth requires consistency and commitment. There are an infinite number of ways you can build a portfolio and always more research to be done. A consistent strategy that doesn’t much attention but is the hallmark of scions like Warren Buffett is Dividend Investing. Dividend investing is in some ways the essence of investing; allocating toward companies with reputable, consistent and profitable business models that pay you quarterly. While the capital gains from AMZN are certainly nice, there is something to be said for receiving cold, hard cash in your account four times a year that you can spend without having to liquidate part of your position.
In this primer I’ll review everything you need to know about dividends and why they are an essential component of your portfolio. Hopefully by the end you’ll have better insight into a simple, repeatable investing process that can generate significant rewards overtime! At the end, I include a list of 40 highly rated, dividend paying stocks that you can reference to build your own portfolio.
Dividends Made Simple
As an equity holder in a publicly traded company you are entitled to a share of the profits. Profits can be used in 1 of 4 ways:
- Held back in cash reserves to be used later to manage cash flow or prepare for an acquisition.
- Reinvested back into the company for expansion or to pay down debt.
- Used to buyback outstanding shares of stock.
- Paid out as cash to shareholders as dividends.
Oftentimes, a company’s dividend policy will be determined by the stage of the company’s life cycle. Younger firms or those in high growth sectors like information tech and biotech typically won’t pay a dividend. Instead, growth companies opt to reinvest profits in an effort to aggressively expand or development new products. Established firms or those in sectors experiencing slower growth like consumer staples or utilities are more likely to pay out a dividend to their investors; their business models are more stable and require less (or simply have less opportunity for) reinvestment.
As a dividend investor you can target companies with strong brands and proven profitably and get paid each quarter. This represents a predictable form of return and cash flow that is not subject to the whims of the market. Dividends can finance your lifestyle or be reinvested to grow your portfolio.
As a dividend investor, there are several variables that you will want to consider when analyzing candidate stocks, namely:
Earnings Yield (EY) is the reciprocal of the more commonly quoted Price-to-Earnings (PE) ratio. It is a popular valuation metric and tells us how expensive a stock is compared to the profits it generates. I generally prefer to use EY over PE because it gives a better sense of relative value and provides a more direct comparison to the yield you receive on bonds.
The Payout Ratio represents the proportion of earnings that are paid out as dividends. The Payout Ratio can give us clues on how sustainable a firm’s dividend is or the investment landscape the company might be facing. Neither a high nor low Payout Ratio is good or bad thing in and of itself. A high Payout Ratio might imply a high willingness to return capital to shareholders. On the other hand it might also signal a lack of viable investment or expansion opportunities. If reinvesting in the company isn’t expected to generate attractive profits, then it makes sense to pay out shareholders. However, such a practice might suggest secular high winds for the firm and its industry and it’s worth considering if the company has long term viability.
The payout ratio can actually eclipse 100% if the firm is taking on debt to finance the dividend. This was the case for GE prior to 2017 as they consistently paid out a dividend despite negative earnings! In retrospect this was probably a short sighted, bad idea. When GE finally cut their dividend in 2017, the share price collapsed from ~$20 and now trades for less than $6 (as of 5–6–20).
The graph below illustrates the payout ratio for the S&P since 1970. The Payout Ratio can be quite volatile owing to changes in corporate policy and earnings cyclicality. We observe that it has declined notably from the average of the 70’s, 80’s and 90’s. It also tends to spike during recessions like 2001 and 2008 as companies continue to pay dividends even as their earnings decline.
The final metric that you’ll want to consider as a dividend investor is, of course, the Dividend Yield (DY)! The Dividend Yield represents the dividend divided by the share price, expressed as a percentage. In short, it is the take home pay from your investment. Pulling together what we have learned so far, we can easily calculate the Dividend Yield using Earnings Yield and the Payout Ratio:
Dividend Yield (DY) = Earnings Yield (EY) x Payout Ratio
Much like EY, DY is an essential valuation metric and is directly comparable to bond yield. Unlike EY however, DY will actually tend to rise during a recession and decline during economic expansions. As investors sell out of stocks as the economy slows down, the dividend will increase relative to the share price and make investing in stocks relatively more attractive as compensation for the added risk. The below graph illustrates the evolution of the Earnings Yield and Dividend Yield for the S&P. EY has declined substantially since its peak in the 1970’s. This reflects that stock price appreciation has outstripped the underlying Earnings growth. The Dividend Yield, other the other hand, has declined more modestly and has settled in at ~2% for the last two decades (notice the spike in 2007–2008).
Dividends in a Portfolio
Warren Buffet loves dividend stocks. In 2020, Buffet and Berkshire Hathaway are on track to rake in almost $4B in dividend income! His portfolio of stocks includes stalwart dividend names like Coca-Cola (KO) which he has held for decades, JP Morgan (JPM), and Kroger (KO), but also Apple (AAPL) which has the nice feature of being both a high-powered tech stock and dividend payer (seriously, it’s like the perfect holding!).
You’re probably not Warren, but dividends are an equally important part of your own portfolio as the graph below illustrates. If had you started investing in the S&P 500 in 1970 and reinvested all of your dividends back into the index, then your total return through the end of 2019 would be 14,594%! Conversely, had you only received the price appreciation of the S&P and not consistently reinvested your income then your return would have only been a paltry 3,409%. To put this into dollar figures, $10,000 invested in the S&P in 1970 and assuming you reinvest your dividends would now be worth $1,459,476, but only $340,942 without. Over 75% of your total return is due to reinvesting your dividends and allowing them to compound!
The contribution of dividends to the total return of the S&P has varied over time. As the below graph demonstrates, in the 1970’s dividends provided about 72% of the decade’s total return.
This percentage has declined significantly from its peak partly due to changes in corporate policy. In recent years, corporations have given preference to stock buybacks rather than dividends. Both are ways of returning profits to shareholders, but the tax treatment of a buyback v. a dividend is slightly different. Under certain circumstances buying back stock may be more tax efficient than issuing a cash dividend.
Moreover, once a company begins to pay a dividend there is an implicit assumption that it will never stop paying, or even cut, the dividend. A dividend cut is viewed as a sign of a company in serious distress (again, consider the case of GE). However, investors have historically given firms greater discretion with respect to buy backs which allows them to adjust policy accordingly. While reducing a buyback program is still not viewed as a positive, for some reason it carries far less stigma than a dividend cut.
When building your portfolio, it’s vital to consider your return objectives and risk tolerance. Investing in dividend stocks won’t necessarily create excess shareholder wealth over time since the stock price usually declines on the day the stock begins to trade ex-dividend (i.e. without its dividend). The reason for this is intuitive: a company has a certain amount of cash on its balance sheet, which is reflected in the value of its equity, once that cash is paid out the equity necessarily has to decline to offset the change in assets. It’s important that your dividend strategy be analyzed from a total return perspective accounting for both income and capital appreciation.
Stocks to Get You Started
In this primer we learned the basics of dividend investing. Dividends continue to be an important component of an investor’s return and a stable source of cash flow. Furthermore, dividend investing is a simple and repeatable investment process which has historically performed quite well! To wrap up, below is a list of some stock picks from Bank of America/Merrill Lynch Global Research that I have screened for above average dividend yields and +10% annualized dividend growth over the past 5 years. Hopefully this list helps to get you started!
Thanks for reading!
Originally published at http://lightfinance.blog on May 9, 2020.