I have highlighted below several frequently asked questions about dividend investing. This is not an all inclusive list, but more of a running total of questions I am usually asked about dividend investing, dividend growth stocks and my strategy. The answers pertain to my investing, strategy and experience, and I have tried to respond to the best of my knowledge and intentions. As I get new recurring questions asked, I would add them to this list.
Why should you focus on dividends?
A company that pays dividends is less risky than a company that has never paid a dividend. A company that pays dividends pays with actual cash, which cannot be easily manipulated like earnings. Dividends are a more stable part of total returns, and are always positive, which is what makes them ideal for retirees who want to live off their nest egg. Paying a dividend imposes discipline on management, that makes them evaluate the cash flow impacts of new projects and make them only focus on the best ideas. This dividend payment makes management less likely to engage in empire building, and less likely to simply hoard cash or mindlessly expand/acquire companies which are not accretive to returns. Few US managements are willing to cut a dividend – doing so sends signals that the company is weak financially.
What are you looking for in a dividend stock?
In my entry criteria, I focus on companies which manage to increase dividends over time because they have growing earnings, trade at a P/E below 20, yield above 2.50% and have a dividend payout ratio below 60%. I have violated some of those rules before, but I have also focused on only buying companies that can increase earnings and not paying more than 20 times earnings. I also do qualitative analysis in order to understand the business of the company, whether it has any moat, competitive advantages, strong brands, pricing power and the ability to increase earnings over time.
How to you handle dividend payments?
As an investor in the accumulation phase, I re-invest dividends selectively. This means that I accumulate cash dividends all the way up to $1,000 or $2,000, and then purchase shares in a company I believe to be attractively valued. I am not a fan of automatic dividend reinvestment, unless of course your portfolio is so tiny that the transaction costs would negate any benefit of investing in the cheapest stocks. I target 6%– 7% in annual dividend growth, coupled with a 3% – 4% yield on my portfolio, for a total of 10% in dividend income increase every year. Once I retire and live off my portfolio, I would spend all of the income, and would rely on organic dividend growth to keep up with inflation.
When would you sell a dividend stock?
I usually sell after a dividend cut, after a company I own is acquired, or if it becomes too overvalued for the growth I expect out of it. For example in 2012, Con Edison (ED) traded at a yield of 4% despite the fact that it was growing distributions at less than 1%/year for the past 16 years. In addition, shares of Universal Health Realty Income (UHT) were similarly overvalued relative to their dividend growth. I try to buy great stocks that would do great things in increasing earnings, dividends and stock prices, but sometimes life happens and either growth slows down, the stock gets massively overvalued or the financial conditions deteriorate. My expectation is to never sell when I buy (otherwise, why would I buy in the first place), although I monitor frequently my portfolio. I expect that my best ideas would go up over 1000% in my lifetime, and I would keep holding on to them until I pass them over to my heirs. These would be the stocks that would generate large portions of my returns. Selling a stock that will go up by 1000% in 20 – 30 years for a small gain without letting it ride out to full potential will likely cost a lot, and could mean you lose money in dividend investing rather than make any.
Don’t only companies that do not grow pay dividends? Companies that cannot find anything better to invest money in tend to pay dividends.
It is true that companies like Google (GOOG) have never paid a dividend; nor did Apple (AAPL) pay a dividend between 1997 – 2011, when its stock rose a lot. However, most companies that do not pay dividends do so because they cannot afford to because they have deteriorating financials or need all of the money to be reinvested in the business, as they are not generating excess cash flows. If you focus on companies that do not pay a dividend, chances are that few will be the Googles or Berkshire Hathaway’s (BRK.B) of the world, but most might be the Worldcom’s, General Motors, Eastman Kodak’s etc.
Actually, some of the best performing stocks have managed not only to grow business but also pay a rising dividend over time. Such companies include Wal-Mart (WMT), McDonald’s (MCD) and Coca-Cola (KO). My goal is identifying these companies that not only increase earnings and dividends, but also trade at a reasonable valuation. That being said, not all companies that pay dividends are good investments. Please check above on the factors I look for in a stock.
But Warren Buffett doesn’t believe in paying dividends – Berkshire has not paid a dividend since 1967
Berkshire Hathaway has not paid dividends since 1960’s. However, Buffett does invest in businesses and companies that pay dividends, and he uses these cash flows to invest in other cash generating stocks and businesses. This is similar to what dividend investors do – buy stocks and then reinvest them in other attractively valued stocks if in the accumulation stage. If you are retired, then chances are you still reinvest your excess cash in more dividend stocks. While Buffett is an excellent capital allocator, few other companies can match his expertise. Most companies that invest excess earnings into other relevant businesses or unrelated industries have a poor track record. The sole fact that there is just one Berkshire Hathaway but over 100 dividend champions speaks volumes.
But what about total returns?
As I mentioned above, I focus on companies that I believe will increase earnings per share over time. This is the driver behind dividend growth over time. A company with rising earnings per share would likely increase in price over time. As a result, I do hope that the companies I buy will be more valuable over time, and would generate total returns. However, I focus on dividends because they are a more reliable portion of total return than capital gains for living off your nest egg.
What about taxes?
Qualified dividends derived from US corporations are taxed at a maximum tax rate of 23.80% to US residents. This is much lower than tax rates on interest income, which is taxed much higher at the ordinary income tax rates (except muni-bonds). Unfortunately, if your income is less than $400,000 for single or $450,000 for joint returns, you would pay anywhere from 0% to 15%.
Taxation varies for REITs and MLPs, and is unique to the entity paying them and the