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In some recent articles, here and here, the authors questioned whether or not buying dividend stocks makes sense. I would like to address some of the points they made and discuss why, for me, DGI makes the most sense as compared to other types of investing.

In both articles their main point is that when a stock goes ex-dividend the price automatically drops an equivalent amount to the dividend payout, and therefore the stock and your individual holdings, are worth no more the day after the dividend then they were the day before.

If we freeze the value of every other asset and liability and focus just on the cash, then it must hold true that the value of the company will drop in an amount equal to the cash that it gives away with the dividend.

They argue that it is simply a shifting of money from the company's bank account into your own, and that it does nothing to increase your wealth. This is true, but it is not the entire picture. As Benjamin Graham famously said "In the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine." DGI is a long term investing principle, and is not interested in the day to day change in the stock price. Over time the price will return to the true valuation of the company based on its earnings potential and its dividend yield.

In fact, both authors admit that the price usually returns to the pre ex-dividend price fairly quickly. Although the cash that the company has on its balance sheet is a factor in the valuation of the company, it is usually a small factor, and paying out the dividend usually makes little difference. It is the company's earnings that are most important in determining the stock price, and more specifically its future earnings, not its present ones.

If the company's long term prospects for increasing earnings are good then the share price will quickly return to the price it was before the dividend payout, and will continue to go up over the long term. In the meantime the investor still has that dividend sitting in his bank account, has reinvested it in the stock, or has put it to use in another investment.

Another argument they make is that if the company you are investing in is such a good company then why can't they find better ways to use the money then by giving it back to the investors. They feel the company should keep the money and use it to expand their business in profitable ways. By paying out the dividend they are put at a competitive disadvantage to competitors who do not pay dividends and therefore have more money for growing their business.

The dividend paying company is put at a disadvantage and subsequent to paying a cash dividend has less money available to expand the business or make acquisitions. By extension, society suffers from the loss of potential investment in the business.

Once again I understand their point, but I feel it is fairly inconsequential. I personally, as do most DGI investors (based on articles and comments I read on Seeking Alpha), look for companies with relatively low payout ratios (such as Aflac (AFL), 23% or Illinois Tool Works, (ITW) 37%). Due to the nature of their businesses, even after paying the dividend they still have plenty of cash left over to invest in growth opportunities. Dividend Growth Investor just wrote a nice article discussing the extra cash many companies create (here).

If there was evidence that the most common DGI companies were not making acquisitions, not investing in R&D, not expanding factories, and not hiring, all because they had to use their money to pay a dividend, and did not have enough cash left over to do these activities, then I would admit the authors have a point. I have never seen any such evidence. If a dividend paying company does start running low on cash it will either freeze or cut its dividend, and for many DGI investors this is a clear sell signal.

So I don't understand why these authors are critical of dividends. DGI may not be for everybody, and there are many different ways to invest. They all have good points and bad. Let me explain why I prefer DGI.

1. SIMPLICITY - I've tried reading 10Ks and 10Qs. I've tried reading balance sheets and cash flows. I've tried listening to earnings conference calls. I don't understand them. But I understand a dividend. I know what it means, I know where it comes from, I know when it is coming, and I know how much it will be. And I know that if it is frozen or cut then I will sell the stock. Easy.

2. INCOME - I like owning things which send me payments on a regular basis. I look at dividend stocks as being similar to rental properties. I own them, and every quarter they pay me "rent" in the form of dividends. These dividends immediately get re-invested in the "property" (the stock) to increase its value (over time). Over many years, with the continuing growth of the dividends, and through the magic of compounding, the value of the underlying "property" becomes quite large.

There are other market investments which can also produce income, such as bonds and options, but the income from bonds does not grow over time unless you continue to add to the principle, and options can be very time consuming to find the right strikes, months, and strategy, and if the market moves the wrong way the positions can move against you. Steady, growing income, month after month, year after year, is very appealing to me.

3. MARKET UNCERTAINTY - I don't have to worry about the market. Whether it goes up or down doesn't matter to me. Either way I'm not going to sell my stocks. I am in them for the long term to collect ever increasing dividends year after year. Would I sell a rental property just because tells me its value has fallen? No. Not as long as I am still receiving rent from it. The same holds true for my dividend stocks.

4. LIFESTYLE - I still work full time and am raising teenage children. if I were investing in stocks for capital appreciation I would have to spend a lot of time researching them to decide which ones to buy, and then I would have to follow them closely to look for signs that it is time to sell. Although I still have to do research to decide which dividend stocks to buy, once I buy them I plan on owning them for years, so I don't have to put much time into following them to worry about when to sell. As long as the dividends are still safe I will keep them. It allows me to relax and enjoy other things in life.

5. FAMILIAR COMPANIES - As Peter Lynch famously said, "Invest in what you know." meaning buy stock in companies that you are familiar with. If you love Coca-Cola buy stock in Coke (KO). If you swear by Tide detergent buy stock in Procter & Gamble (PG). Most of the stocks with long histories of raising their dividend payments are companies that make products or provide services which we are all very familiar with. Knowing that I send a check to AT&T (T) every month for the cell phone bill, or that I take the kids to McDonald's (MCD) every weekend, or if we need a quick meal on the run, allows me to know these companies personally. And it makes me feel very secure that these companies will be in business for a long time, will continue to increase earnings year after year, and will continue to pay me dividends, because I use them myself and know how good they are.

6. PREDICTABILITY - I know how much my portfolio is worth right now and how much of each stock I own, I know what my quarterly contribution will be every three months for the next 20 years, and I can calculate how my dividend income will rise by 6-7% (or more) every year. So I am able to have a pretty good estimate of what my income will be when I retire, and what kind of life style I will be able to afford. This will help me make plans for my retirement. If I were investing in non-dividend paying stocks I would be completely at the mercy of the market, and have no idea what resources I will have when I retire.

7. IT WORKS! - Finally, the main reason I use DGI is because it works. Historically, the majority of returns from investing in stocks has come from dividends, and there's no reason to believe this will change. If dividend paying stocks have outperformed non-dividend stocks, then why would I buy non-dividend stocks? I will take the reliable income and the steady capital appreciation, and look forward to a (relatively) stress free retirement.

For the three years I have been doing DGI my portfolio has either matched or beaten the S&P 500 by a percentage point or two every year. And I have seen my dividend collections increase year after year. So I know, from historical studies, that dividend investing works, and I know from my own portfolio that it is working. And that is good enough for me.

Thank you for reading my article. I welcome your comments.

Recent data for some of the stocks mentioned in this article:

CompanySymbolPriceP/EYieldDividendPayout Ratio
AFLACAFL49.788.242.811.4023.18 %
Coca-ColaKO37.1819.362.741.0253.13 %
Ill. Tool WorksITW61.3314.962.481.5237.07 %
McDonald'sMCD86.8016.353.553.0858.00 %

(Thank you to David Fish for the above information.)

Source: Why I Choose Dividend Growth Investing