A Dividend Investing Primer

by: Evelyn C. Roth

Once regarded as a haven for retirees or unsophisticated investors, dividend-paying stocks and ETFs have recently roared into the spotlight as investors of every orientation search for ways to eke out more immediate income from longer term equity holdings.

But judging a stock only by its dividend yield is not necessarily the best way to approach dividend investing. So as an aid to dividend-oriented investors, and with the help of our awesome contributors, I've put together this Dividend Investing Primer which I hope will help readers get the most from their dividend stocks.

Why Dividend Stocks?

Dividend payments are generally made monthly, quarterly or annually. In uncertain times, generating real and reliable income from their portfolio can be a boon to anyone's budget. More importantly, a healthy assortment of dividend-paying stocks can be the backbone for your long-term investment strategy no matter the economic climate, as David Van Knapp notes in Why I Love Dividends.

One traditional knock on dividend stocks has been that, "only poorly-managed companies or companies in decline tend to pay dividends," and that successful companies aggressively reinvest profits to spur innovation and growth. Dividend Growth Investor disagrees: He details a variety of reasons why healthy, thriving companies pay dividends, including corporate constraints on internal asset allocation; a company's position within an already mature industry; and the fact that excessive reinvestment doesn't always guarantee successful growth or development.

Some people even argue that a company's dividend is a leading indicator for its fiscal health - because it's a gauge of management's optimism around the company's future.

Factors to Consider

Many novice dividend investors focus primarily on a stock's yield - assuming that higher is always better. "Unfortunately, high yield stocks often carry higher than average risk," Dividends4Life writes.

What sort of risks? Look for signals such as:

  • Is the company in a limited growth industry?
  • Is it in a particularly volatile industry?
  • Has it experienced recent financial problems?
  • Has its share price fallen?
  • Do shareholders believe there are financial problems on the horizon?

So while yield is clearly a factor to consider, other metrics worth focusing on are included in David Van Knapp's The 4 Qualities of the Best Dividend Stocks:

  1. Initial yield - what does the stock yield today? (David's minimum is 2.5%)
  2. The reliability of the dividend - does the company have a history of paying and growing dividends?
  3. A history of dividend increases - are earnings growing at a clip that will facilitate dividend increases?
  4. The stock's growth potential - over and above dividend increases, are you investing in a solid growth stock?

Companies with a history of paying and raising dividends for at least 25 years are often called Dividend Aristocrats or Dividend Champions (see: Comparing Dividend Aristocrats to Dividend Champions).

Here are five questions Chuck Carnevale asks before investing in a dividend-paying stock:

  1. Are dividends growing, and if so, at what rate, how consistently and for how long?
  2. Has the company ever cut its dividend, and if so, why?
  3. What about the payout ratio - is it reasonable, and is it increasing or decreasing?
  4. What has been the cumulative total amount of dividends paid over a given period of time?
  5. What has been the nominal yield and yield on cost (growth yield) that the stock has delivered?

And a warning from Nicholas Southwick Levis: "Make sure free cash flow covers most or all of the dividend payments made over the past few years." If debt is the primary resource for a company's dividend payments, you're likely looking at a dividend - or even a company - at risk.

Maximizing Dividend Returns

Don't overlook valuation when choosing dividend stocks. Past, present and future earnings will all have a significant impact on the size and distribution of a company's dividend. Price-to-book ratio can also help you gauge the upside potential of a dividend stock by allowing you to determine which stocks are undervalued.

Seasoned dividend investors often look to own a mix of high yielding stocks - for immediate, richer payouts - alongside dividend growth stocks which hold the promise of future lucrative increases. "The dividend growth investment strategy has held up under severe questioning," David Van Knapp, a proponent of this hybrid strategy, writes.

Young and novice investors shouldn't shy away from dividend paying stocks either. Kevin Parker, in 5 Tips for Young Investors Looking to Start Investing in Dividend Stocks, highlights the huge upside:

...dividend stocks are a great area to focus on for new and young investors because they tend to be less volatile, provide a slight buffer against loss because of the dividend, and most importantly, because the philosophy of investing in such stocks tend to be a more conservative long-term approach rather than trading for a quick buck.

Reinvesting dividends can significantly increase your holdings, not to mention your yield on cost. As noted by David Fish in DRIPS Are for Kids (And All Kinds of Grownups Too), there are hundreds of companies - including such Dividend Champions as Abbott (NYSE:ABT), PepsiCo (NYSE:PEP) and Johnson & Johnson (NYSE:JNJ) - that sponsor Dividend Reinvestment Programs (DRIPS), which saves investors from having to use their brokers and incurring additional fees.

More intrepid investors also use options to generate income from both dividend-paying and non-dividend paying stocks in their portfolio. To learn more about generating income using covered calls, the Covered Call Tool has a great tutorial, not to mention a best-of-breed set of tools.

Possible Pitfalls

There's no guarantee that a company will continue to increase or even pay its dividend. In particularly difficult conditions, companies have been known to freeze or even cut their dividend. Aficionados advocate selling a stock when it cuts its dividend, cautioning that it is often the warning sign of more trouble to come. When a dividend is frozen, it's also time to keep a close eye on the stock.

Alternative Dividend Vehicles

MLPs or Master Limited Partnerships are similar to dividend stocks, but often boast significantly higher yields. Because of how they're structured, MLPs are limited to certain types of businesses, such as those involving the extraction or transportation of natural resources such as gas, oil and coal.

Rather than becoming equity holders, MLP owners become limited partners in the parent company, and receive quarterly required distributions, subject to a different set of tax implications than equity dividends.

Another alternative income-generating investment vehicle are REITs - (Real Estate Investment Trusts), which issue trust units rather than shares, and own and manage different types of real estate properties including apartment units, shopping centers and office buildings. Distributions are made quarterly. Because REITs are required by law to 'pass along' or distribute 90% of their income, they don't pay taxes, which makes each unit holder responsible to pay taxes on distributions.

Dividend Investing and Retirement

A portfolio flush with dividend paying stocks, if smartly managed, can generate reliable income for years. No surprise then that retirees have always been drawn to equities that generate regular income.

But a well-plotted, well-planned dividend stock portfolio can be an ace in the hole for any investor, no matter how far off retirement may be, as Dividend Growth Investor describes in The Case for Dividend Investing in Retirement. Dividend stocks, he says, are "a must-own asset class not only for the retired investor who needs income for the next three or four decades, but also for the investor who expects to retire in 30 or 40 years."

Once you're in retirement, how much of your portfolio should you allocate to dividend stocks vs. bonds? David Van Knapp shares the way he made the calculation for himself in Asset Allocation For A Dividend Growth Investor.

So Now What?

To learn more about dividend investing and your portfolio - as well as to join the spirited conversation taking place right now within Seeking Alpha's dividend investing community - start with our Dividend Stock Ideas theme page. There, you'll find a diverse array of informative posts, combined with lively and instructive discussions between contributors and readers in the comments section following each article.

Want even more information on Income Investing? See our Investing for Income dashboard.

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