The Possible Power of Dividend Investing
Stock and ETF investing continues to be popular even after the economic slowdown in 2023. In fact, today's Wall Street Journal reported that individual investors purchased a net $77.7 billion in equities and ETFs (excluding retirement accounts) on the U.S. Exchange in the first quarter of 2023, according to Vanda Research data. Wow!
Among the overall purchases, a subset strategy focused on providing cash flow to investors is the focus of our attention today.
Dividend investing is a popular approach among those seeking to build wealth over time. And why wouldn't it be? Dividends, which are payouts made by companies to their shareholders, can offer a steady stream of income and significantly influence your overall returns. In this article, we will explore the financial returns and impacts of dividend investing, the benefits of reinvesting those dividends, and some strategies to consider when mitigating risks that could sting and knock down your investments.
Why Some Invest in Dividend Paying Companies
Steady income: Dividend-paying stocks (DPS) provide a consistent income stream for investors, distributing dividends quarterly or annually. This income can cover living expenses, supplement other income sources, or be reinvested for further growth.
Lower volatility: DPS tends to be less volatile than non-dividend-paying stocks, as dividends can help cushion the impact of market fluctuations. This can be particularly beneficial for risk-averse investors or those nearing retirement.
Compounding returns: When reinvested, dividends can help compound your returns over time. Reinvested dividends are used to buy more shares of the stock, which in turn will generate more dividend income in the future. By opting for a dividend reinvestment plan (DRIP) or manually reinvesting your dividends, you can take advantage of the power of compounding. **Be Careful*** If you have auto reinvesting, just make sure you want to continue to reinvest. This is not a “set it and forgets it type of plan. It is a set it, think about it, and recommit or change its plan.”
Tax considerations: Dividend income, when classified as qualified dividends, is taxed at the same rate as long-term capital gains, which can be lower than ordinary income rates.
Example of Compounding – The impact of reinvesting dividends:
Suppose you invest $10,000 in a dividend-paying ETF with an annual dividend yield of 4% and an annual appreciation of 5% for a total of 9%.1
From the example noted above, reinvesting dividends can significantly improve your total returns over time, allowing you to grow your wealth once you have invested the time and selected investments you wish to own for longer holding periods.
Risks to Watch Out For
Dividend cuts can significantly impact a dividend-focused investment strategy’s income stream and overall returns. It is crucial to identify and mitigate the risks of investing in companies that may cut their dividends.
Tools and Metrics to help assess the financial health of companies and potentially avoid those that might cut their dividends (Yikes!):
Altman Z-Score: The Altman Z-Score is a widely used financial metric that predicts the probability of a company going bankrupt within the next two years. Companies with low Z-Scores may be more prone to cutting dividends to preserve cash and avoid insolvency.
Dividend payout ratio: The dividend payout ratio is calculated by dividing dividends per share by earnings per share. A high dividend payout ratio could indicate that the company is paying out a significant portion of its earnings as dividends, which may be unsustainable in the long run. 50% or below is generally considered healthy; 80%+ may signal a potential risk of dividend cuts.
Free cash flow (FCF): Free cash flow is the cash generated by a company’s operations that is available for distribution to its stakeholders. Comparing a company’s free cash flow to its dividend payments can help determine if it generates enough cash to sustain its dividend payouts. If a company consistently has a higher FCF than its dividend payments, it is less likely to cut dividends.
Debt-to-equity ratio: The debt-to-equity ratio measures a company’s financial leverage by comparing its total liabilities to its shareholders’ equity. A high debt-to-equity ratio may indicate a company has significant debt, making it challenging to maintain dividend payments, especially during economic downturns or periods of financial distress. You will see some companies loaded up on debt during the low-rate environment, those you should pay close attention to.
Dividend growth history: Analyzing a company’s dividend growth history can provide insights into its commitment to maintaining or increasing dividend payments. Companies with a long track record of stable or growing dividends are less likely to cut dividends, as they tend to prioritize returning value to shareholders. A good question is whether the company knows its shareholder base and the reasons they own its stock vs. another company’s stock. Make sure there is alignment; otherwise, the relationship will sour.
Earnings stability and growth: Companies with consistent earnings growth and stability are less likely to cut dividends. Regularly monitoring a company’s earnings reports, financial statements, and analyst forecasts can help you gauge its future earnings potential and likelihood of maintaining dividend payments. Yep, it’s work to be an investor, but if you want to understand what drives the markets, understanding the companies you own directly or through an ETF is the way to go.
What’s the goal of looking at any of these tools or metrics? Identify companies with a lower likelihood of cutting dividends and better manage the risks associated with your dividend-focused investment strategy. No one metric can provide a complete picture of a company’s financial health or predict future dividend cuts. It’s essential to use a combination of these tools and conduct thorough research before making any investment decisions.
When a dividend investing strategy could be out-of-favor
Shift in focus to growth stocks: Over the past few decades, the focus has shifted towards growth stocks, expected to achieve above-average growth rates in earnings and revenues. Capital appreciation was prioritized over dividend-paying stocks in these cases, assuming they offer a higher potential return depending on what you have owned; that might have been the case in the past.
Lower dividend yields: The average dividend yield has decreased over time as stock prices have risen, and many companies prefer to invest in growth initiatives or repurchase their shares rather than pay dividends. This trend has made dividend investing less appealing to investors seeking higher income streams.
Perceived lower returns: Dividend-paying stocks are seen as more conservative investments, and some investors may believe they provide lower returns than other investment strategies. Hey, dividend stocks can offer a steady income stream and lower volatility. While they might not give the same level of capital appreciation as growth stocks, this is a strategy several investors do appreciate, including the chairman of Berkshire Hathaway, Warren Buffett.
Tax considerations: When you have more non-qualified dividends which are taxed at the individual’s ordinary income tax rate, which can be higher than the long-term capital gains tax rate. This tax treatment may make dividend investing less attractive to some investors, especially those in higher tax brackets who receive non-qualified dividends—examples: REITs, Master Limited Partnerships, etc.
Market trends and performance chasing: Investors often follow market trends and performance, which may lead to a preference for currently performing strategies. During periods when growth stocks or other investment approaches outperform dividend-paying stocks, dividend investing may lose popularity.
The complexity of analyzing dividend stocks: Assessing dividend-paying companies’ financial health and sustainability requires thorough research and analysis of various financial metrics. Yep, it’s work and a reason why folks outsource this work to fund managers such as ETFs.
Despite these factors, dividend investing remains a viable and valuable strategy for many investors, particularly those seeking a consistent income stream, potential lower volatility, and potential long-term growth through dividend reinvestment.
New to the Strategy? Be aware of these risks:
Interest rate risk: DPS is often sensitive to changes in interest rates (like what is going on in 2023). When interest rates rise, investors may shift their focus to lower risk higher rate investments like Treasury Bills and Notes or Bank CDs, which may offer higher yields with lower risk. This shift in focus could lead to a decline in demand for dividend stocks and a subsequent decrease in stock prices.
Dividend sustainability: Not all companies have the financial strength to consistently maintain or increase their dividend payments. Early investors should pay close attention to a company’s financial health, including its earnings stability, free cash flow, and payout ratio, to assess the likelihood of dividend cuts or suspensions. Take a look at the tools and metrics mentioned earlier.
Economic downturns: During economic declines, some companies may face more significant financial difficulties, which could lead to dividend cuts or suspensions (like what happened during the COVID crisis). Early investors should diversify their portfolio across various sectors and industries, consider ETFs, etc., to mitigate the impact of economic downturns on their dividend income.
Overemphasis on dividend yield: Focusing solely on high-dividend-yielding stocks can be risky, as a high yield may be a sign of financial distress, lack of market confidence, or an unsustainable dividend payment. So, consider other factors such as dividend growth, payout ratio, and overall financial health when selecting dividend-paying stocks.
Lack of diversification: Investing exclusively in DPS may lead to a lack of diversification within an investment portfolio. Consider diversifying investments across various asset classes, sectors, and regions to reduce risk and improve long-term returns.
Currency risk: For early investors investing in foreign dividend-paying stocks, fluctuations in currency exchange rates can impact the value of dividends received and the overall investment returns. There is more complexity with foreign investments, including the potential currency risk associated with international dividend investments.
Regulatory and tax changes: Pay close attention to tax laws and regulations changes, which can impact dividend-paying stocks and their attractiveness to investors. For example, changes in dividend tax rates, the table of when the rate changes from 0% to 15% to 20%, or the treatment of qualified dividends could alter the after-tax returns of dividend-paying stocks.
Slow capital appreciation: DPS may not offer the same level of capital appreciation as growth stocks. Consider whether a balanced portfolio with a mix of dividend and growth stocks may suit you.
Things to Consider:
Dividend investing can offer numerous advantages, including a steady income stream, lower volatility, and the potential for compounding returns. By reinvesting your dividends, you could possibly maximize the overall returns and accelerate the journey toward financial flexibility. As with any investment strategy, it’s essential to carefully consider your financial goals and risk tolerance before making any decisions. It’s up to you. For some, dividend investing and reinvesting dividends can be a powerful strategy for achieving long-term financial sustainability.
Next Steps:
Set aside an hour. Turn on some of your favorite tunes. Make this a sweet time to learn about your current dividend strategy. You have one whether you know it or not.
Look at your recently filed tax return. See how much you have in qualified dividends vs. ordinary dividends.
If you don’t know what assets pay you a dividend, log into your brokerage account, 401k account, etc. and review your statements for the past five quarters. It will show you which ones are paying a dividend.
If you have more than one brokerage account for all your accounts, take time to review all your accounts and quarterly reports.
See if you have automatic reinvesting turned on.
Take time to determine if this asset class is suitable for you. Journal your thoughts, fears, dreams, plans, and cash flow.
Connect with a financial advisor who is a fiduciary. If you don’t have one, find a firm with advisors who are paid a salary and are not incentivized to offer advice based on a product or service.
Disclaimer:
This information is for educational purposes only. As with any investment strategy, it’s crucial to understand the risks, benefits, and individual circumstances before making any decisions. Understand the concerns and risks and make informed decisions when investing in dividend-paying stocks. Thorough research, diversification, and a long-term investment horizon could help mitigate these risks.
The calculated value is based on an annual dividend.