Why Invest in Dividend Paying Stocks?

Investing in Dividend-paying stocks over time is the best way to build not only real wealth but real passive income.  To be clear, dividend stocks are not a ‘get rich quick’ scheme…but they are a get rich- with certainty- scheme.  The reason dividend-paying stocks are so powerful is because they combine the two most important aspects of wealth generation:

  1. Capital Gains
  2. Passive Income

Consider the following example:  Pepsi stock currently trades for about $70 and pays a dividend of $2.06 for a yield of 2.9%  Now, that may not seem like much now…but let’s take a look at Pepsi’s stock back in 1980.  Back in March of 1980, Pepsi traded for about $24 but that doesn’t mean that it took 30 years for Pepsi’s stock price to double…it grew at a much greater rate than that – if we look at the March 1980 share price adjusted for dividends and stock splits, then Pepsi’s stock traded at $0.59 and paid a dividend of $0.01583 for a yield of about 2.7% (not much different from today).  But look at what happened over the last 3 decades:  Pepsi’s stock went from $0.59 to $70!  And the dividend grew from one and a half pennies each year to over $2 today!

Had you invested $2,000 in Pepsi stock in 1980, it would have grown to more than $200,000 by 2011, paying out over $5,500 in dividends every year.  This isn’t just an isolated example, either.  With Phillip Morris, your $2,000 back in 1980 would’ve grown to over $670,000 today and would be paying over $9,600 a year in dividends.

There are hundreds of examples like this and most of them are well known companies that were also well known back in 1980…so it’s not like an investor would’ve had to pick the next Google or Microsoft to have earned that money.  It’s the dividends continuously reinvesting that do the heavy lifting for you.

Since the 1960’s Pfizer has increased its dividend 4200%…someone who had reinvested those dividends would’ve earned over 13,000%.  Johnson & Johnson increased its dividend 9,700%…Coca-Cola increased its dividend 4,700%.  Dividends are truly the backbone of real returns over time.

The key to this spectacular accumulation of wealth is the power of compounding dividends.  In both of these examples, the reinvested dividends account for well over half of the wealth created.  By focusing on the best dividend stocks, especially those that will increase their dividends over time, you can build a powerful passive income machine.

Thanks to the power of compounding, a portfolio of top dividend paying stocks can actually pay significantly more on an annualized basis over time even if stock prices stay absolutely flat.

Let’s look at another useful example – the S&P BMI (Broad Market Index) World Index. Excluding dividends, a $100 investment made in the S&P BMI World Index on January 1, 1999 would have grown to $318 by the end of 2007. Over that same period, a $100 investment with dividends reinvested would have grown to $468.50.

 

Clearly, dividends demonstrate an important role in generating real wealth over time that has gone largely unnoticed by the broader investment community…at least in the last few decades.  The reason is that dividend paying stocks generally aren’t considered “sexy”…especially in recent years when internet start-ups have captured most investors’ attention.  That wasn’t always the case, however.  For years, a stock’s dividend yield was the primary way investors valued a company.  The reason was simple – a high dividend also represented a high degree of dependability and transparency on the part of the company.  Dividend payouts, especially increasing dividend payouts, reflect management’s confidence in the sustainability of cash flow generation.  Also, dividends are the ultimate form of transparency -  returning the cash to the people that own it…the shareholders.  The bottom line is – dividends are an important sign of a healthy company

For this reason – stocks with higher dividends, for years, were considered safer investments.  Similar to a company that pays higher salaries and gives higher raises over time.  A shift occurred in the 1990’s, though, as companies with extremely high growth prospects (but little, or no, earnings) came to dominate the landscape.  That’s not to say these companies were completely without merit…the internet (and technology, in general) ushered in a new paradigm of truly transformational companies with spectacular growth prospects.

But making a bet on a company’s future growth is exactly that…a bet on future growth.  While, dividends reflect the health of a company’s growth right now.

Things are beginning to change.  The wild capital appreciation in the 90’s allowed investors to bet on tiny internet companies that were little more than ideas…and make millions from huge run-ups in the stock when things hit big.  Since 2000, however, the story has changed.  Capital appreciation is no longer considered an entitlement by participants in the equity market and dividends have now become an increasing source of reliable returns.  As John D. Rockefeller once said, “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”

Downside Protection

Another important characteristic of dividend paying stocks is their stable nature.  A stock’s dividend is the less volatile component of its total return and is much more predictable than price appreciation which is a function of a wide array of factors like speculation, market sentiment, macro-economic factors, etc.

From 1989 to 2008, the volatility of the S&P BMI index was 13.96%, while the annual volatility of dividends was only 0.27%!

Of the stocks included in the S&P 500 Index, 256 began or increased their dividends in 2010, compared to only five that stopped or decreased their dividend, according to Standard and Poor’s.  And 42 of those stocks had increased their dividends each year for the past 10 years.

In “The Future for Investors,” Jeremy Siegel advocates a long term dividend-reinvestment strategy based on research showing that dividend-paying stocks have outperformed non-dividend payers over time. The same can be said of today’s dividend payers. The S&P 500 Dividend Aristocrats have outperformed the S&P 500 Index over the one-, three-, five-, 10-, 15-, and 20-year periods ended Dec. 31, 2010.

 

Important Factors

Now that we’ve established that dividend paying stocks are an integral part of building sustained wealth over time, the next step is to narrow our focus on which dividend paying stocks to invest in.  Especially if we’re deciding to invest for the long-haul, it’s important to remind yourself that you’re not just buying a stock…you’re actually buying a fractional ownership in a company.  And in return for this ownership interest you will be entitled to any cash earnings that management decides to pay out in the form of dividends.  Remember, however, that not all dividends are created equal and several factors must be considered before committing your hard-earned cash.  Approach this problem as if you were buying the entire company…not just making a few mouse clicks on Etrade.

So, what should you consider when choosing a dividend paying stock?

1.   Initial yield – what does the stock yield today? This is, after-all, the point of investing in dividend-paying stocks…to get the dividend, so it should compare favorably to other dividend-paying instruments, namely bonds & bank CDs.  The current environment happens to be extremely favorable for dividend investing but over the years this hasn’t necessarily always been the case.

2.   The reliability of the dividend – this is an important point.  Many people get seduced by a super-high dividend only to see the company cut it in order to save cash.  A lot of companies did this in 2008 and in many cases, it was actually a prudent deployment of capital.  After all, if a company is facing bankruptcy or cutting its dividend in order to build up its balance sheet, the dividend should go…but that’s little consolation if you were an investor counting on that dividend.

It’s important to look for:

  • A steady history of uninterrupted dividend payouts (preferably with increases) over several years
  • A sustainable payout ratio.  If a company is paying out too much of its earnings as dividends then it’s more likely that it will have to tap into that source of cash to deal with any future hardships.
  • A solid business model and favorable economic environment going forward.  This, of course, is easier said than done but there’s a reason companies like Coca-Cola have been able to pay a dividend every year for 58 years…they’ve got a solid business model that has been able to weather most macro-economic environments.  Consider the pre-2008 period when many REITs were sporting high yields.  When the housing bubble burst, many of these companies (like apartment-owner Equity Residential and shopping mall operator Simon Property Group) had to cut their dividend payments just to stay afloat…believe it or not, a lot of prudent dividend investors saw this coming and were able to get out of the way.
  • A disciplined management team committed to paying and increasing the dividend over time

3.   A history of dividend increases – this is crucial because of the power of reinvested dividends.  An increase in the dividend is every bit as important as the size of the dividend.  Consider a company paying a 3% dividend that increases that dividend by 10% each year.  Then, in year 2, the yield on your initial investment will be 3.3%.  The following year, it will be 3.63%.  By year 10, your effective dividend yield will have more than doubled to 7%.

4.   The stock’s growth potential – this is an important point because it represents a huge advantage that dividend-paying stocks have over traditional “fixed income” investments such as bank CDs and bonds…equities can appreciate over time.  This goes hand-in-hand with the points listed above.  If a company can continue to pay (and increase) its dividend over decades, then its likely a company that will demonstrate an ability to grow its market cap as well.

 

 

10 Responses to Why Invest in Dividend Paying Stocks?

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