Part III – Dividend Investing Considerations
Sid Roy & Sanjib Saha
22 December 2024
9. What are the unique risks associated with a dividend paying stock?
In general, companies pay and increase dividends to signal financial health. This creates a false impression that all companies that issue dividends are stable companies. Conversely, dividend cuts are perceived as company’s downfall, even though such cuts are necessary for long-term prospects. These perceptions influence management decisions about managing the company’s ongoing income and distract management’s focus from the overall wellbeing of the business.
Dividend paying stocks expose the investor to these additional human bias of its directors – the avoidance of such companies to reduce or pause dividend payments even when the company is going through a rough patch and could make better use the cash to survive or prosper. Dividend considerations and manipulation of shareholder sentiments in company decisions can thus potentially turn out to be imprudent and detrimental for the long term.
Companies which issue dividends also come in different flavors. Some might be issuing dividends but might have underlying financial issues. So, it is best to not think of dividends as inherently safe in any way. These investment vehicles should be treated with the same due diligence as others.
10. How to assess a stock on the merit of its dividends?
For academic interest, here are a few key indicators to evaluate dividends. While we suggest further reading for in-depth knowledge, we do not encourage engaging in active dividend-stock picking.
- Dividend Yield: This number, expressed as a percentage of the annual dividend ( per share) divided by the current share price, is a measure of how much income to expect by investing in this particular stock. This is analogous to interest rate of Bank Deposits, except that unlike bank interest, dividends are not guaranteed, and unlike the principal amount of the Bank Deposit, the share price will most certainly change and so will the amount invested in this particular stock. High dividend yield might imply a struggling company with depressed share price, or a slow-growth company, or something unusual.
- Dividend Payout Ratio: This number tells what percentage of the company’s net income is paid out as dividends. A high number implies that the company spends most of its income in dividends and therefore has less leeway to increase dividends, or even sustain it at challenging times.
- Dividend Consistency: The consistency of paying dividends over a period of time is an indicator that the company management has been disciplined and committed to paying dividends.
- Dividend Growth Rate: The percentage growth of dividend over a period of time shows that the company not only has a track record of dependable dividends, but also the dividend has been increasing year over year. A low dividend growth rate is generally not a good indicator as the dividend income might not keep pace with inflation.
11. What are the different ways to invest in dividend stocks?
Active stock pickers screen companies for dividends and subsequently analyzes the candidate companies to asset their investment merit. Thankfully, there’s a much easier alternative: Invest through dividend-focused funds (Exchange Traded Funds, Mutual Funds or Closed End Funds).
Broadly speaking, there are two informal categories of dividend-focused funds: One prefers companies that have a high payout (High Dividend Yield) and the other prefers companies that have a history of not only paying dividends, but also growing them steadily. Intuitively, the second category sounds better as they tend to select solid companies with great track records. However, all investments are great when bought at the right price and awful if bought when overpriced.
Closed End Funds (CEFs) are often attractive to income seeking investors as many CEFs endeavor to produce a hefty and regular monthly income. Like any other investment, it’s important not to get lured by attractive income prospects. As always, buyers beware!
12. What role can dividends play in my investment portfolio?
Dividend earning stocks can give a regular income stream and potentially some modest investment growth too. The convenience aspect of the income stream without having to actively sell investments is definitely attractive. At the same time, there are many alternatives such as bonds, CD ladders, (rightly priced) annuities and so on, that don’t require tilting the portfolio towards dividend-paying investments. While Dividend Investing can be suitable for many investors for various reasons, there is no reason to rush to such an approach without evaluating all the aspects. It’s a perfectly fine decision for long-term investors to be oblivious to dividends and simply invest in low-cost, diversified stock funds.
We hope that our discussion shed some light on the basics of Dividend Investing and clarified any misconceptions you might had.
Happy Investing!