Dividend Investing Basics

dividend investing basics“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in”. This is a quote from John D. Rockefeller which from one hand I find extremely sad (he must have had a pathetic life if he really meant it), on the other hand it’s true that seeing the companies paying you dividends (no matter how big or small) just for the honor that you own their shares is an extremely satisfying feeling. And this is just one of the many reasons why the members of my dirty thirty portfolio are all dividend paying companies. To see the other reasons, please read further.

A well established, profitable, shareholder friendly firm with positive outlook for the future. Sounds like something that you might want to own, and these are exactly the characteristics of a typical dividend paying company. A dividend is basically a distribution of a portion of a company’s earning or reserves. Of course not all companies pay dividends and they are not necessarily bad companies. In fact it would be quite irresponsible from young, growing companies who are just extending at the market to pay their earnings (if they have at all) as dividends, instead of reinvesting it in their future grows. Companies like Google (sorry, Alphabet), Tesla, Facebook, Amazon don’t pay dividends at all, and still their share price worth 4, 5 or even 10 times more than five years ago. Actually such a rapid share price increase is not typical for well-established dividend payers. So why do I still prefer them?

The answer is: for multiple reasons. But the first of them is that I know my limits. I simply do not have enough knowledge and information to be able to identify such young companies in an early stage that actually worth investing in. When Facebook went public in 2012, I had no idea whether it’s share worth 30, 130 or 3 USD. I still don’t and I rather don’t touch it. What I want to see in my early retirement portfolio are companies that not just that pay dividends, but whose dividend payment is safe, have relatively good yield, and have a good track record of increasing dividends. But how can I find such companies?

Let’s check the list of the aristocrats!

investing in dividend aristocrats

The what? Yes, there is an actual list, called the dividend aristocrats. You can find the most up to date one here. They are companies who are member of the S&P500 and that have increased their dividend in at least the last 25 years. Currently 7 companies (ADM, CL, EMR, HCP, T, TGT, XOM) of my dirty thirty are members of the dividend aristocrats. Why not all? The main reason is diversification. Some of these companies have very low yield (I don’t buy anything under 2%), I don’t want to get exposed only to one type of group of companies, furthermore European companies are excluded from this list by definition.

Of course there are a bunch of other ways how you can further search for good dividend payers. The typical questions I generally look the answer for:

  • Has the company cut its dividend during 2008-2009? If no, that generally shows a crisis resistant company with a shareholder friendly management.
  • Does the earning or free cash flow safely cover the dividend? I typically look for a dividend layout payout ratio of maximum 60%
  • Does the company increase its dividend based on the last couple of years an if yes, what’s the rate of increase?

Of course if you don’t want to do any research at all, there are also some great ETFs out there that invest in dividend paying stocks.

This all sounds good, but is investing in dividend paying companies a good idea in all different kinds of economic environment that I can expect during the way to my early retirement? Well, history says that at least it’s never a bad idea; in fact on a long term dividend paying stocks (especially with reinvested dividends) outperform the ones that don’t pay dividends. If you are looking for a detailed analysis, I recommend reading this one. In a nutshell, a study of the University of Chicago showed that:

– the average annual total return of dividend payers is higher than the non-payers

– their annualised standard deviation is lower

– they keep their value better during bear markets

The research has also shown that there is a difference between dividend payer and dividend payer. They have categorized the companies into 5 quintiles (Quintile 1 representing the bottom 20%, Quintile 5 the top 20% in terms of dividend yield) and found that in all the examined categories Quintile 4 was performing the best.

Why is that? The answer is most likely the yield trap. Many companies have fallen into Quintile 5 that paid unsustainable high dividends. This has eventually led to dividend cut and share price fall. Conclusion: Don’t go for the highest yields! Go for the highest yields that are paid out in still a sustainable manner.

Finally I want to mention that based on my early retirement investment principles I never cash out the received dividends but reinvest them. This leads to the magic of compounding. To demonstrate what it means, let’s take two companies, A and B. You have EUR 10,000 saving each year to invest in them plus you can also reinvest the received dividend (if any). The share price of both companies in year 1 is EUR 10. Company A is paying 3% dividend and its share price is increasing also by 3% every year. Company B does not pay any dividend, but its share price is rising consistently every year.

If you invest in company A, in the 5th year, you will have 5,000 shares from company A that worth EUR 56,275. The share price of company A has risen to EUR 11.26, which is a 13% increase. Since company B hasn’t paid dividend, but its share price has increased, you could purchase less and less shares each year. At the 5th year, you will have 4,469 shares which means the share price should be at least EUR 12.60 in order to be better off than by investing in company A. That’s a 26% increase vs 13%. Of course it’s not impossible, it just shows that non dividend payers always start with handicap versus dividend paying companies.

Company A
Year Share price Invested amount Number of shares purchased Value
1             10.00                       10,000                                                  1,000            10,000
2             10.30                       10,300                                                  1,000            20,600
3             10.61                       10,609                                                  1,000            31,827
4             10.93                       10,927                                                  1,000            43,709
5             11.26                       11,255                                                  1,000            56,275
Company B
Year Share price Invested amount Number of shares purchased Value
1             10.00                       10,000                                                  1,000            10,000
2             10.60                       10,000                                                      944            20,595
3             11.23                       10,000                                                      891            31,820
4             11.89                       10,000                                                      841            43,714
5             12.60                       10,000                                                      794            56,311

 

Do you have questions? Do you agree or disagree? Feel free to post your comment below!

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