When it comes to investing in the equities markets, the options are nearly limitless. There are individual companies, ETFs, mutual funds, and many combinations of these toward which investors can put their capital. When options to limit losses or lock in gains are added to the equation, some people become overwhelmed and decide investing is too complicated. They can then become prey for advisors charging massive fees for their advice.
When it comes to investing, it would be crazy to pass up the next Wal-Mart (NYSE:WMT) or Apple (NASDAQ:AAPL). For example, an individual who purchased Wal-Mart at the beginning of 1980 when it was just starting to really expand its footprint would now have a cost basis of $0.09 per share, according to Yahoo! Finance, when accounting for splits and dividends. Had an investor put money toward Apple at the beginning of 1997, just before Steve Jobs returned to the helm of the ship and before the iPod, iPhone, or iPad were a reality, they would now have a cost basis of just $0.69 per share when adjusted for splits and dividends. These are pretty impressive returns in anyone's book. The problem, however, is figuring out what the next Wal-Mart or Apple might be.
For every Apple or Wal-Mart, there are also companies like Exodus Communications, Enron, or MCI WorldCom that are supposed to be the next big thing and go belly-up and cause investors to lose massive sums of money. Those who invested in these companies might have seen some serious capital gains for a while, but in the end, the stocks became basically worthless. It is for this reason that I've decided upon a strategy of investing in dividend-paying companies. Here are three reasons I believe dividend investing is a solid long-term strategy.
1. Dividends Are Real Cash Returns on Invested Capital
To pay out a dividend, a company either has to have the cash on hand or borrow to do so. A company that has to borrow to pay over the longer term will eventually lose the ability to borrow additional funds to pay for the dividend. This is where the dividend payout ratio and the free cash flow are very important to look at. A company that pays out less in dividends than the income it brings in should be able to continue to pay the dividend over the long haul. Every dividend that an investor receives is a return on the capital that they've invested. Over time, the dividends received should come close to equaling or even exceeding, sometimes by a very large margin, the capital investment. These dividends are real money can then be spent or reinvested, depending upon the station in life that an investor might currently be at.
2. Dividend Aristocrats Are Loath To Cut Their Dividends
Companies like Johnson and Johnson (NYSE:JNJ) and Coca-Cola (NYSE:KO) who have built up 53 year records of increasing their dividends are not terribly interested in ending this streak unless absolutely necessary. Even some companies that do not have a major streak of increasing their dividends have a longer streak without dividend cuts. One notable example is Royal Dutch Shell (RDS.A, RDS.B). This oil major has not provided an increase in the past couple of years, but it has not cut dividends since 1945. It was literally during the throes of World War II when Shell last cut its dividend. While the current oil market with very low prices may require a dividend cut eventually, the company has noted its commitment to paying the current dividend throughout 2016. No Shell CEO wants to be the one who saw the dividend cut on his or her watch. A long-term history of paying dividends is a sign of stability that can attract investors toward your company, and this is a benefit that firms do not take lightly.
3. Even Stable Dividends Pay Out More Over Time
The power of compounding requires that a dividend of $0.10 a quarter will necessarily result in an increase in dividend income over time, provided that dividends are reinvested. For example, if a company that's valued at $40 a share pays out a $0.10 dividend on a quarterly basis, and an investor has 100 shares, that investor would get $10 in dividend income for the first quarter. This dividend could then go toward 0.25 additional shares of the stock, making the holding 100.25 shares. The next quarter, the dividend income would go up to $10.03. By the end of year one, the dividend income would go up to $10.08 per quarter, and the hypothetical investor would hold 100.7519 shares. At the end of ten years, this hypothetical investor would have 110.2277 shares giving off $11.02 per quarter. This assumes that the cost per share stays stagnant and that the dividend stays stable over 10 years. It also assumes a dividend yield of 1 percent per year.
If the dividend yield were 3 percent and the yield and stock price stayed the same over ten years, the power of compounding is more evident. Under this scenario, the total holding would go up to 133.8311 shares paying off $40.19 in dividend income for the last quarter of the ten-year period. This is with no dividend growth whatsoever, but the yield on cost has grown to 4.01 percent, and the dividend payment would continue to grow into the future. It's also important to remember that the dividends do not have to be reinvested in the same company. They can be used to diversify into other companies that might be priced more attractively with stable dividend yields. While this is a simplistic exercise with hypotheticals, it's perhaps helpful to look at a real-world example.
I recently wrote an article on AT&T (NYSE:T) that showed that what many people at the time believed was dead money was actually quite lucrative for the long-term investor. At the time, T had only provided a capital gain of around 19 percent total over a 20-year period. This article was written before the recent run-up in the price of AT&T shares, but it showed that an investor could expect income from this company to go up by 7 or 8 percent on an annualized basis if it was reinvested into more shares of T. This was based upon a 5.75 yield and an estimated 2 percent growth in the annual dividend, which has been quite common over the past few years. Today, the yield on AT & T shares is down to "only" 4.62 percent, as the price per share has gone up from $35 to $41. If we figure in the same 2 percent dividend growth, investors could expect their income to go up around 6.5 percent in the next year, which is better than most raises from actually working. If additional revenue from the purchase of DirecTV and expanded activity in Latin America leads to better net income (which some expect), perhaps the raise will be more in line with 4 percent or even more, which would add up to a raise in income of more than 8 percent if the dividends are reinvested. This is only one concrete example, among many, of how dividend rates that stay stable or increase cannot help but go up over time when reinvested because of compounding.
Dividends provide several benefits for investors. While capital gains are nice, they can be erased pretty quickly in a down market. Dividends are real cash that companies pay out to investors. This income can then go toward investing in other high-quality companies, toward reinvesting into more shares of the same company, or toward any expense that an investor might have, be it traveling the world or paying run-of-the-mill bills. Furthermore, when reinvesting dividends over the long haul, even a stable dividend will pay off with an ever-increasing stream of this cold, hard cash for investors. A growing dividend will grow even faster because of the power of compounding, and in some instances, usually over a period of decades, will even exceed the initial investment on an annualized basis. These are three reasons that I've chosen to invest in dividend-paying companies.
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Disclosure: I am/we are long T, WMT, AAPL, KO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not a licensed investment professional. This article is only for educational/entertainment purposes. Please consult with a professional and do due diligence before investing in equities markets, as losses up to an including all capital invested can occur.