Do's and Don'ts of dividend investing
02 January, 2015
Investing in shares that pay good dividends is a great way for investors to ensure a steady stream of income. With share market listing of the State-owned power companies, or 'gentailers', last year a lot of investors will have thought all their Christmases had come at once; dividend yields made term deposit rates look paltry.
But while dividend investing seems conservative and straightforward on the surface, there is quite a bit that investors should know to maximise long term wealth.
- Dividends have historically accounted for a reasonable portion of total returns from shares around the world. In the US going back 80 years, dividends have comprised 40 per cent of the total returns of the S&P 500 Index. However, the ratio of dividends to total return has not been steady nor consistent. That is, sometimes dividends are a good source of return and sometimes they are less so. Capital gains tend to comprise a much larger proportion of total return during bull markets and buoyant times, whereas dividends make up a larger proportion when markets are nervous or negative. It would be foolhardy to expect that dividends will always be a big contributor to your returns.
- The payout ratio is an important number to monitor. Dividends are supposed to be a mechanism for companies to share their financial success with shareholders — if they make a profit, they keep some for future growth and they pay some out to shareholders. While dividends don't, strictly speaking, always have to come from the earnings of that year, it is not sustainable for a company to consistently pay out more than it earns. The payout ratio is a measure of how much of the company's profit is paid out in dividends. If a company earns $1 per share in profits and pays out a 70 cents per share dividend, its payout ratio is 70 per cent. If the same company paid a dividend of $1.20 per share, the payout ratio would be 120 per cent and shareholders should be asking questions about how the company can continue to pay dividends in excess of its earnings. Companies like to maintain consistent or rising dividends even when their earnings can be volatile. It may be forgivable for a company to pay out more than they have earned in a given year, in the expectation that future earnings will cover past dividends, but no company can indefinitely pay out more than it earns.
- Instead of chasing the highest dividend yield (the dividend per share divided by the share price and expressed as a percentage), investors can be better off accepting a lower dividend and finding companies that continually put shareholders first by growing their dividends for decades on end. Well-known international companies including Coca-Cola, PepsiCo and Procter & Gamble have yields in the 2-4 per cent range but they've raised their dividend payouts every year for 25 years or more. Regular, reliable dividend increases give investors confidence a company can weather the ups and downs of the economy and still succeed in growing their business. The promise of reliable dividend growth for years ahead is far more valuable than a sky-high dividend yield today and a wiser path towards long-term wealth.
- While many investors consider cash is king and nothing is nicer than receiving a dividend cheque, re-investing dividends can make a lot of sense. Using your dividend to buy more shares can be a powerful avenue to increase your wealth over time. By re-investing, your money 'stays active' in the company and accumulates value. It is basically about the effect of compounding — a 5 per cent annual dividend is nice but, if you re-invest that dividend, you can earn further returns — potentially turning it into 6 or 7 per cent or more.
Dividend-paying stocks have found their way into investors' portfolios for many years (the first dividend is thought to have been paid in the 16th century) and for many reasons (a stream of income being the main one). Dividend stocks are more attractive than ever in a low interest rate environment but investors should nevertheless focus on the sustainability and dependability of long-term income rather than chasing the hottest yield of the day.