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Dividend Investing: A Primer

Long regarded as a haven for retirees or investors with little market savvy, 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 hardly the only, nor necessarily the best way to juice dividend holdings. So I've put together this Dividend Investing Primer with links to a comprehensive array of articles written by some of our savviest contributors on how to get the most from your dividend stock portfolio.

Why Dividend Stocks?

As most investors already know, dividends are the regular payments companies disburse to shareholders either from current or retained earnings. Payments are generally made monthly, quarterly or annually. In uncertain times, that can be a boon to anyone's budget, as well as the backbone for one's long-term investment strategy no matter the economic climate, notes David Van Knapp in Why I Love Dividends.

Though nonbelievers claim, "only poorly managed companies or companies in decline tend to pay dividends" pointing out that earnings should always be re-invested back into the company to spur innovation and growth, Dividend Growth Investor details a variety of reasons why healthy, thriving companies opt to pay dividends, including corporate constraints on internal asset allocation, and the fact that excessive reinvestment doesn't always guarantee successful growth or development.

Some investors even believe that the state of a company's dividend can be its leading indicator, signaling management's optimistic view of the company's fortunes and future. 

What Factors to Consider

Most novice dividend investors begin by focusing on
a stock's yield, assuming that higher is always better. "Unfortunately, high yield stocks often carry higher than average risk," notes Dividends4Life. What sorts 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?

Though yield should not be minimized as a consideration of course, there are a number of other metrics worth focusing on including what David Van Knapp calls the 4 qualities of the best dividend stocks:

  • the safety of the dividend
  • the reliability of the dividend
  • a history of dividend increases
  • the stock's own growth potential

Companies with a significant history of raising and continually paying dividends are often called either Dividend Aristocrats or Dividend Champions, depending on which organization is keeping track. These stocks have consecutively raised their dividends for upwards of 25 years [see: Comparing Dividend Aristocrats to Dividend Champions].

Of course, not all dividend stocks are equally good investments, even when they offer the same (or similar) yields. Chuck Carnevale lays out several questions worth asking in this post, including:

  • Are the dividends growing, and if so, at what rate and how consistently and for how long?
  • Have they ever cut their dividend, and if they did, why?
  • What about the payout ratio; is it reasonable and is it increasing or decreasing?
  • What has been the cumulative total amount of dividends paid over a given period of time?
  • What has been the nominal yield and yield on cost (growth yield) that the stock has delivered?
"Make sure free cash flow covers most or all of the dividend payments made...over the past few years and quarters," says Nicholas Southwick Levis. 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 also look to own a mix of high yielding stocks, for immediate, richer payouts, alongside dividend growth stocks, which though sparsely paid out at the time of purchase hold the promise of future lucrative increases. "The dividend growth investment strategy has held up under severe questioning," says proponent David Van Knapp, here.

Reinvesting dividends can significantly increase your holdings, not to mention your yield on cost. According to 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), obviating the need for a brokerage account.

More intrepid investors have also been known to use options to help boost income beyond dividends received.

Possible Pitfalls

Of course, there's no guarantee that a company will continue to increase or even pay its dividend. During particularly difficult years, many companies have been known to freeze or cut their dividend. Aficionados advocate selling a stock when it cuts its dividend, considering that the first sign of more troubles to come. However, when a dividend is frozen, it's recommended that one keep a closer eye on the stock to see if the dividend outlook might improve in upcoming quarters.

Alternative Dividend Vehicles

MLPs, or Master Limited Partnerships are similar to dividend stocks but often have significantly higher yields. Because of the way 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, purchasers become limited partners (or unit holders), and receive quarterly required distributions, subject to a different set of tax ramifications than equity dividends.

Some investors are more comfortable with real estate. In that case, REITs, Real Estate Investment Trusts, which issue trust units rather than shares and usually own and manage different types of real estate properties including apartment units, shopping centers and/or office buildings might be for them. 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 for the tax ramifications of their individual distributions.

What About 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 these equities. But a well plotted, well planned dividend stock portfolio can be the ace in the hole of any investor, no matter how distant their retirement may be as Dividend Growth Investor succinctly lays out 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."