10 Tips For First Time Dividend Investors by Ben Reynolds
Do you remember the first time you purchased a stock or mutual fund?
I can look back on when I first started investing – and how little I knew. Investing knowledge isn’t inherited, it is learned.
Wise men and women learn from other people’s mistakes. Better that than learning from your own mistakes. Investing can have very high learning costs.
This article has 10 important tips for first time dividend investors. I wish I had known these 10 tips when I first started investing.
Even if you are not a first time investor, these tips will help reinforce your dividend investing knowledge and help prevent against future behavioral investing errors.
Table of Contents
Each of the 10 tips are listed below:
- Don’t Chase Yield
- Look for Quality Dividend Stocks
- Understand Valuation
- Focus on the Business
- Invest for the Long Run
- Don’t Obsess Over Returns
- Be Prepared to Lose Money When The Market Falls
- Know Why You Will Sell
- Stay In Your Circe of Competence
- Have an Investing Plan
Tips For First Time Dividend Investors #1: Don’t Chase Yield
One of the most common mistakes that first time investors make is chasing yield.
Dividend investors are looking for dividends. That means a higher yield is always better, right? That is not always the case.
The highest yielding stocks are often very risky. Ultra-high yield is there to compensate investors for the extreme risk. Taking big risks is not a good way to create stable, growing dividend income.
It also doesn’t produce the highest total returns…
One of the biggest misconceptions in investing is that risk is always directly related with return. The idea that riskier stocks must somehow return more sounds like it makes sense. But the real world data does not validate this hypothesis.
Low volatility (and the very similar low beta) stocks have historically outperformed high volatility (or high beta) stocks.
This phenomena is not just observed in price volatility. More to the point for dividend investors, the highest yielding stocks don’t produce the highest total returns.
The 2nd highest yielding quintile (stocks between top 20% and top 40% in yield) have actually produced the best returns on both an absolute and risk adjusted basis.
You can see how to quickly find dividend stocks in this quintile here. Stocks in the second quintile of yield currently have a yield of between 2.9% and 4.5% in today’s market.
If you are looking for sustainable and growing dividends, don’t invest in stocks with 10% or 20% yields (I am sure there are a few exceptions, but in general). Instead, focus on quality with a ‘good enough’ yield.
Tip #2: Look for Quality Dividend Stocks
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” — Warren Buffett
Saying you should look for quality dividend stocks is like saying you should buy a good car… It doesn’t mean much. What exactly is quality?
It’s difficult to accurately pin quality down quantitatively. Does it mean a high profit margin? If so, are Amazon (AMZN) and Wal-Mart (WMT) low quality businesses? I don’t think so.
Does it mean a low stock price volatility? If so, is Archer-Daniels-Midland (ADM) a weak business? I don’t think so.
Does it mean a long operating history? Then I suppose Google (GOOG) is not a quality business.
Finding the ‘perfect’ metric for quality is impossible. Finding a good metric that excludes most ‘low quality’ businesses (and some high quality businesses) is about the best we can hope for.
As a dividend investor, I prefer to use a long history of steady or rising dividend payments to greatly narrow the search for high quality businesses. Specifically, I use the cut off of 25 years.
For a business to have paid steady or increasing dividends for 25 years it must have (or at least very recently had) a strong competitive advantage. There’s no way to produce reliable results over a long period of time without having some insulation against competitive forces. I would call this a ‘quality’ business.
Businesses with long histories of rising dividends have historically performed very well. The Dividend Aristocrats Index is comprised of 50 businesses with 25+ years of consecutive dividend increases. You can see the excellent historical performance of the Dividend Aristocrats over the last decade below:
Source: S&P Fact Sheet
The aforementioned stock price volatility also makes a decent proxy for quantifying quality. Businesses with stable outlooks tend to see their stock prices bounce around less than businesses with higher risks, all other things being equal.
Quality can be observed qualitatively as well. It is something that is rather difficult to pin down. Being familiar with a business helps to determine its level of quality. For example, anyone familiar with Coca-Cola (KO) could easily say it has a stronger competitive advantage than a startup in the beverage space.
Thinking about how difficult it would be for a competitor to beat a company in a competitive environment is a good way to think about the quality of a business. How hard would it be to go head to head with Coca-Cola? You’d need billions in advertising spending every year. That alone forms a strong competitive advantage.
Quality is important, but not at any price.
Tip #3: Understand Valuation
The Warren Buffett quote from tip 2 also applies to tip 3. Buffett likes quality when it is marked down.
This means, look for quality businesses that are trading below their fair value. Like saying ‘invest in quality’, saying to invest in ‘undervalued’ securities is easier said than done.
Every business has an intrinsic fair value that is the sum of its future cash flows discounted to present value using an appropriate discount rate.
The problem is, we don’t know the sum of future cash flows or the appropriate discount rate to use. This makes finding the true intrinsic value impossible.
Looking at price-to-earnings ratios is a good substitute. The price-to-earnings ratio shows how much people are willing to pay today for a dollar of earnings. The higher the price-to-earnings ratio, the faster earnings are expected to grow. Higher price-to-earnings ratios also imply a greater degree of safety; a higher probability that earnings will occur.
In short, higher price-to-earnings ratios mean people have higher expectations of a business in the future. Lower price-to-earnings ratios show general pessimism about the future.
The S&P 500’s average price-to-earnings ratio is 15.6. The lowest it has ever been is 5.3 (in 1917). The highest it has ever been (excluding periods when earnings dropped precipitously, throwing off the usefulness of the ratio) is 32.9 in January of 1999 (during the tech bubble).
These are valuation levels for the whole market. Looking at individual stocks shows a different perspective:
- Netflix (NFLX) has a price-to-earnings ratio of 289.1
- General Motors (GM) has a price-to-earnings ratio of 3.9
It doesn’t take a genius to know that Netflix has better growth prospects going forward than General Motors. Investors have bid up the price of Netflix because they expect great things from it.