If you want steady income and a cushion against declining stock prices, then the answer is a resounding, yes – dividends are a good investment stock strategy. Dividends are quarterly payouts in stock or cash based on a percent of the stock price. They are especially attractive in a low interest rate environment when government and corporate bonds, and other income paying investments are delivering low returns.
Companies with a long track record of paying dividends tend to consistently pay and increase their dividends, making dividend paying stocks one of the few investments that can deliver a solid return in bull and bear markets.
Why Investors Love Dividends
Investors are devoted to their dividend paying stocks. They hold onto them for a long time and are rewarded with steady income for their loyalty. Such devotion helps to lessen price volatility in these stocks. The top three reasons investors buy dividend stocks are:
- Dividends are paid out quarterly providing a steady income stream
- Dividend reinvestment allows you to increase your exposure to good stocks. Successful value investors buy companies that pay dividends and reinvest those dividends in the same or similar stocks.
- Dividends help to cushion decreases in a stock price. If a high dividend paying stock declines a few percent during a stock downturn, the dividends could more than offset that loss.
Dividends and Value Investing
Typically, there is a trade-off between high growth stocks that pay investors through stock market-beating returns and value stocks that pay investors through both stock appreciation and dividends.
The technology stalwart IBM is a good example of the traditional dividend paying stock. IBM has paid a dividend since 1972. Its current dividend yield is an attractive 3.72%. On today’s share price of $134.57, that translates to a payout of about $5.20 per share. IBM’s dividend has been growing for 15 years. With the exception of a few bumps, including some flat to down years in the early 2000s, IBM’s dividend yield has steadily increased.
Apple (AAPL), on the other hand, has a dividend yield of 1.84%, which it has been paying since September 2012 (and a brief dividend history from 1988—1995). The iPad maker paid investors a dividend of $0.52 in November 2015, a sharp drop from $3.05 a year ago. As a high growth stock, Apple has rewarded investors with stock returns and a volatile dividend payout, while IBM the reliable blue chip has rewarded investors with a combination of stock returns and increasing dividend yields Generally, a company with a solid dividend history will deliver both steady stock and dividend returns over time.
For examples of good value stocks that pay dividends, take a look at Warren Buffet’s top dividend paying stocks for 2015.
How to Choose Dividend Stocks
Dividend Yield – Most investors start by checking out a list of high dividend yielding stocks. You want to compare your stock’s dividend yield to that of its peers. Some sectors such as real estate investment trusts (REITs), utilities and energy are known to pay high dividends. First, look at how your stock dividend yield compares to its sector dividend yield.
Dividend increases – Some companies faithfully increase their dividends. If the dividend payout is volatile, the risk of the stock underperforming the market is higher.
Dividend Payout Record – Does the company have a good track record of paying out a dividend each quarter? The return on dividend stocks will be slightly lower than, say, a growth stock that provides no dividend. If you are investing in the stock for its dividend income stream, you want to make sure the dividend will be paid. A history of dividend payments is a good indicator of future dividend performance.
Invest in High-Quality Businesses – You want to avoid buying a stock only for its dividend yield. Ensure it is a business with strong fundamentals – steady profit growth, good cash flow and manageable debt ratios. If the company is not earning profits, money may need to be diverted to pay debt, forcing the company to cut dividends. Seek companies with strong operating earnings and cashflow.
Avoid Shrinking Dividends – If a company is reducing its dividend, it means it is generating less profit and cash to pay out the dividend. Stocks with diminishing dividends have historically delivered poor investment returns for their investors.
Do not forget to diversify your portfolio. High dividends are nice, but prudent investing practices should still rule. Avoid putting all of your stocks in real estate investment trusts, for example, because they are paying a high yield. If the economy hits a recession, people will have trouble making their mortgage payments and the value of REITs will fall.
Companies that meet all of the above criteria are easy to find. They are called the dividend aristocrats and many of this elite have been steadily paying dividends to their investors for 25 years.
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