In This Chapter
Getting familiar with income stock fundamentals
Selecting income stocks with a few criteria in mind
Checking out utilities, REITs, and royalty trusts
Investing for income means investing in stocks that provide you with regular cash payments (dividends). Income stocks may not seem to offer stellar growth potential, but they're good for a steady infusion of cash. If you have a low tolerance for risk, or if your investment goal is anything less than long term, income stocks are your best bet. In this chapter, I explain the basics of income stocks, show you how to analyze income stocks with a few handy formulas, and describe several typical income stocks.
Tip
Getting your stock portfolio to yield more income is easier than you think. Many investors increase income using proven techniques such as covered call writing. Covered call writing is beyond the scope of this book, but I encourage you to find out more about this technique and whether it applies to your situation. Talk to your financial advisor or read up on it — it's covered more fully in Stock Options For Dummies by Alan R. Simon (Wiley). You can also find great educational material on this option strategy (and many others) at the Chicago Board Options Exchange (www.cboe.com).
I certainly think that dividend-paying stocks are a great consideration for those investors seeking greater income in their portfolios. I especially like stocks with higher-than-average dividends (typically 4 percent or greater) that are known as income stocks. Income stocks take on a dual role in that they can appreciate but also provide regular income. The following sections take a closer look at dividends and income stocks.
When people talk about gaining income from stocks, they're usually talking about dividends. A dividend is nothing more than money paid out to the owner of stock. You purchase dividend stocks primarily for income — not for spectacular growth potential.
A dividend is quoted as an annual number but is usually paid on a quarterly basis. For example, if a stock pays a dividend of $4, you're probably paid $1 every quarter. If, in this example, you have 200 shares, you're paid $800 every year (if the dividend doesn't change during that period), or $200 per quarter. Getting that regular dividend check every three months (for as long as you hold the stock) can be a nice perk.
Tip
A good income stock has a higher-than-average dividend (typically 4 percent or higher).
Note
Dividend rates aren't guaranteed — they can go up or down, or in some extreme cases, the dividend can be discontinued. Fortunately, most companies that issue dividends continue them indefinitely and actually increase dividend payments from time to time. Historically, dividend increases have equaled (or exceeded) the rate of inflation.
What type of person is best suited to income stocks? Income stocks can be appropriate for many investors, but they're especially well-suited for the following individuals:
Conservative and novice investors: Conservative investors like to see a slow-but-steady approach to growing their money while getting regular dividend checks. Novice investors who want to start slowly also benefit from income stocks.
Retirees: Growth investing (which I describe in Chapter 8) is best suited for long-term needs, while income investing is best suited to current needs. Retirees may want some growth in their portfolios, but they're more concerned with regular income that can keep pace with inflation.
Dividend reinvestment plan (DRP) investors: For those investors who like to compound their money with DRPs, income stocks are perfect. For more information on DRPs, see Chapter 19.
Income stocks tend to be among the least volatile of all stocks, and many investors view them as defensive stocks. Defensive stocks are stocks of companies that sell goods and services that are generally needed no matter what shape the economy is in. (Don't confuse defensive stocks with defense stocks, which specialize in goods and equipment for the military.) Food, beverage, and utility companies are great examples of defensive stocks. Even when the economy is experiencing tough times, people still need to eat, drink, and turn on the lights. Companies that offer relatively high dividends also tend to be large firms in established, stable industries.
Tip
Some industries in particular are known for high-dividend stocks. Utilities (such as electric, gas, and water), real estate investment trusts (REITs), and the energy sector (oil and gas royalty trusts) are places where you definitely find income stocks. Yes, you can find high-dividend stocks in other industries, but you find a high concentration of them in these industries. For more details, see the sections highlighting these industries later in this chapter.
Before you say, "Income stocks are great! I'll get my checkbook and buy a batch right now," take a look at some potential disadvantages (ugh!). Income stocks do come with some fine print.
Income stocks can go down as well as up, just as any stock can. The factors that affect stocks in general — politics (Chapter 15), economic trends (Chapter 10), industry changes (Chapter 13), and so on — affect income stocks, too. Fortunately, income stocks don't get hit as hard as other stocks when the market is declining, because high dividends tend to act as a support to the stock price. Therefore, income stocks' prices usually fall less dramatically than other stocks' prices in a declining market.
Income stocks can be sensitive to rising interest rates. When interest rates go up, other investments (such as corporate bonds, U.S. treasury securities, and bank certificates of deposit) are more attractive. When your income stock yields 4 percent and interest rates go up to 5 percent, 6 percent, or higher, you may think, "Hmm. Why settle for a 4 percent yield when I can get 5 percent or better elsewhere?" As more and more investors sell their low-yield stock, the prices for those stocks fall.
Another point to remember is that rising interest rates may hurt the company's financial strength. If the company has to pay more interest, that may affect the company's earnings, which in turn may affect the dividend.
Note
Dividend-paying companies that are experiencing consistent falling revenues tend to cut dividends. In this case, "consistent" means two years or more.
Although many companies raise their dividends on a regular basis, some don't. Or if they do raise their dividends, the increases may be small. If income is your primary consideration, you want to be aware of this fact. If you're getting the same dividend year after year and this income is important to you, rising inflation becomes a problem.
Say that you have XYZ stock at $10 per share with an annual dividend of 30 cents (the yield is 30 cents divided by $10, or 3 percent). If you have a yield of 3 percent two years in a row, how do you feel when inflation rises 6 percent one year and 7 percent the next year? Because inflation means your costs are rising, inflation shrinks the value of the dividend income you receive. Fortunately, studies show that in general, dividends do better in inflationary environments than bonds and other fixed-rate investments. Usually, the dividends of companies that provide consumer staples (food, energy, and so on) meet or exceed the rate of inflation.
The government usually taxes dividends as ordinary income. Fortunately, recent tax legislation has favored dividend-paying stock. See Chapter 21 for more information on taxes for stock investors.
As I explain in the previous section, even conservative income investors can be confronted with different types of risk. (Chapter 4 covers the topic of risk in greater detail.) Fortunately, this section helps you carefully choose income stocks so that you can minimize potential disadvantages.
Tip
Look at income stocks in the same way you do growth stocks when assessing the financial strength of a company. Getting nice dividends comes to a screeching halt if the company can't afford to pay them. If your budget depends on dividend income, then monitoring the company's financial strength is that much more important. You can apply the same techniques I list in Chapter 8 for assessing the financial strength of growth stocks to your assessment of income stocks.
You choose income stocks primarily because you want or need income now. As a secondary point, income stocks have the potential for steady, long-term appreciation. So if you're investing for retirement needs that won't occur for another 20 years, maybe income stocks aren't suitable for you — better to invest in growth stocks because they're more likely to grow your money faster over your stated lengthy investment term. (I explain who's best suited to income stocks earlier in this chapter.)
If you're certain you want income stocks, do a rough calculation to figure out how big a portion of your portfolio you want income stocks to occupy. Suppose that you need $25,000 in investment income to satisfy your current financial needs. If you have bonds that give you $20,000 in interest income and you want the rest to come from dividends from income stocks, you need to choose stocks that pay you $5,000 in annual dividends. If you have $80,000 left to invest, you need a portfolio of income stocks that yields 6.25 percent ($5,000 divided by $80,000 equals a yield of 6.25 percent; I explain yield in more detail in the following section).
You may ask, "Why not just buy $80,000 of bonds [for instance] that yield at least 6.25 percent?" Well, if you're satisfied with that $5,000 and inflation for the foreseeable future is zero, then you have a point. Unfortunately, inflation will probably be with us for a long time. Fortunately, steady growth that income stocks provide is a benefit to you.
Tip
If you have income stocks and don't have any immediate need for the dividends, consider reinvesting the dividends in the company's stock. For more details on this kind of reinvesting, see Chapter 19.
Every investor is different. If you're not sure about your current or future needs, your best choice is to consult with a financial planner. Flip to Appendix A for helpful financial planning resources.
Note
Because income stocks pay out dividends — income — you need to assess which stocks can give you the highest income. How do you do that? The main thing to look for is yield, which is the percentage rate of return paid on a stock in the form of dividends. Looking at a stock's dividend yield is the quickest way to find out how much money you'll earn versus other dividend-paying stocks (or even other investments, such as a bank account). Table 9-1 illustrates this point. Dividend yield is calculated in the following way:
| Dividend yield = Dividend income ÷ Stock investment |
The next two sections use the information in Table 9-1 to compare the yields from different investments and to show how evaluating yield helps you choose the stock that earns you the most money.
Table 9-1. Comparing Yields
Investment | Type | Investment Amount | Annual Investment Income (Dividend) | Yield (Annual Investment Income ÷ Investment Amount) |
|---|---|---|---|---|
Smith Co. | Common stock | $20 per share | $1.00 per share | 5% |
Jones Co. | Common stock | $30 per share | $1.50 per share | 5% |
Wilson Bank | Savings account | $1,000 deposit | $40 (interest) | 4% |
Note
Don't stop scrutinizing stocks after you acquire them. You may make a great choice that gives you a great dividend, but that doesn't mean the stock stays that way indefinitely. Monitor the company's progress for as long as it's in your portfolio by using resources such as www.bloomberg.com and www.marketwatch.com (see Appendix A for more resources).
Most people have no problem understanding yield when it comes to bank accounts. If I tell you that my bank certificate of deposit (CD) has an annual yield of 3.5 percent, you can easily figure out that if I deposit $1,000 in that account, a year later I'll have $1,035 (slightly more if you include compounding). The CD's market value in this example is the same as the deposit amount — $1,000. That makes it easy to calculate.
How about stocks? When you see a stock listed in the financial pages, the dividend yield is provided, along with the stock's price and annual dividend. The dividend yield in the financial pages is always calculated as if you bought the stock on that given day. Just keep in mind that based on supply and demand, stock prices change every day (virtually every minute!) that the market's open, so the yield changes daily as well. So keep the following two things in mind when examining yield:
The yield listed in the financial pages may not represent the yield you're receiving. What if you bought stock in Smith Co. (see Table 9-1) a month ago at $20 per share? With an annual dividend of $1, you know your yield is 5 percent. But what if today Smith Co. is selling for $40 per share? If you look in the financial pages, the yield quoted would be 2.5 percent. Gasp! Did the dividend get cut in half?! No, not really. You're still getting 5 percent because you bought the stock at $20 rather than the current $40 price; the quoted yield is for investors who purchase Smith Co. today. They pay $40 and get the $1 dividend, and they're locked into the current yield of 2.5 percent. Although Smith Co. may have been a good income investment for you a month ago, it's not such a hot pick today because the price of the stock doubled, cutting the yield in half. Even though the dividend hasn't changed, the yield changed dramatically because of the stock price change.
Stock price affects how good of an investment the stock may be. Another way to look at yield is by looking at the investment amount. Using Smith Co. in Table 9-1 as the example, the investor who bought, say, 100 shares of Smith Co. when they were $20 per share only paid $2,000 (100 shares times $20 — leave out commissions to make the example simple). If the same stock is purchased later at $40 per share, the total investment amount is $4,000 (100 shares times $40). In either case, the investor gets a total dividend income of $100 (100 shares times $1 dividend per share). Which investment is yielding more — the $2,000 investment or the $4,000 investment? Of course, it's better to get the income ($100 in this case) with the smaller investment (a 5 percent yield is better than a 2.5 percent yield).
All things being equal, choosing Smith Co. or Jones Co. is a coin toss. It's looking at your situation and each company's fundamentals and prospects that will sway you. What if Smith Co. is an auto stock (similar to General Motors in 2008) and Jones Co. is a utility serving the Las Vegas metro area? Now what? In 2008, the automotive industry struggled tremendously, but utilities were generally in much better shape. In that scenario, Smith Co.'s dividend is in jeopardy while Jones Co.'s dividend is more secure. Another issue is the payout ratio (see the next section). Therefore, companies whose dividends have the same yield may still have different risks.
Note
You can use the payout ratio to figure out what percentage of a company's earnings is being paid out in the form of dividends (earnings equal sales minus expenses). Keep in mind that companies pay dividends from their net earnings. Therefore, the company's earnings should always be higher than the dividends the company pays out. Here's how to figure a payout ratio:
| Dividend (per share) ÷ Earnings (per share) = Payout ratio |
Say that the company CashFlow Now, Inc. (CFN), has annual earnings of $1 million. Total dividends are to be paid out of $500,000, and the company has 1 million outstanding shares. Using those numbers, you know that CFN's earnings per share (EPS) is $1 ($1 million in earnings divided by 1 million shares) and that it pays an annual dividend of 50 cents per share ($500,000 divided by 1 million shares). The dividend payout ratio is 50 percent (the 50-cent dividend is 50 percent of the $1 EPS). This number is a healthy dividend payout ratio because even if CFN's earnings fall by 10 percent or 20 percent, it still has plenty of room to pay dividends.
Tip
People concerned about their dividend income's safety should regularly watch the payout ratio. The maximum acceptable payout ratio should be 80 percent, and a good range is 50–70 percent. A payout ratio of 60 percent and lower is considered very safe (the lower the percentage, the safer the dividend).
Note
When a company suffers significant financial difficulties, its ability to pay dividends is compromised. (Good examples of stocks that have had their dividends cut in recent years due to financial difficulties are mortgage companies in the wake of the housing bubble bursting and the fallout from the subprime debt fiasco. Mortgage companies received less and less income due to mortgage defaults, which forced the lowering of dividends as cash inflow shrunk.) So if you need dividend income to help you pay your bills, you better be aware of the dividend payout ratio.
Bond rating? Huh? What's that got to do with dividend-paying stocks? Actually, a company's bond rating is very important to income stock investors. The bond rating offers insight into the company's financial strength. Bonds get rated for quality for the same reasons that consumer agencies rate products like cars or toasters. Standard & Poor's (S&P) is the major independent rating agency that looks into bond issuers. S&P looks at the bond issuer and asks, "Does this bond issuer have the financial strength to pay back the bond and the interest as stipulated in the bond indenture?"
To understand why this rating is important, consider the following:
A good bond rating means that the company is strong enough to pay its obligations. These obligations include expenses, payments on debts, and declared dividends. If a bond rating agency gives the company a high rating (or if it raises the rating), that's a great sign for anyone holding the company's debt or receiving dividends.
A poor bond rating means that the company is having difficulty paying its obligations. If the company can't pay all its obligations, it has to choose which ones to pay. More times than not, a financially troubled company chooses to cut dividends or (in a worst case scenario) not pay dividends at all.
Tip
The highest rating issued by S&P is AAA. The grades AAA, AA, and A are considered investment grade, or of high quality. Bs and Cs indicate a poor grade, and anything lower than that is considered very risky (the bonds are referred to as junk bonds). So if you see a XXX rating, then . . . gee . . . you better stay away! (You may even get an infection.)
Note
If most of your dividend income is from stock in a single company or single industry, consider reallocating your investment to avoid having all your eggs in one basket. Concerns about diversification apply to income stocks as well as growth stocks. If all your income stocks are in the electric utility industry, then any problems in that industry are potential problems for your portfolio as well. See Chapter 4 for more on diversification.
Although virtually every industry has stocks that pay dividends, some industries have more dividend-paying stocks than others. You won't find too many dividend-paying income stocks in the computer or biotech industries, for instance. The reason is that these types of companies need a lot of money to finance expensive research and development (R&D) projects to create new products. Without R&D, the company can't create new products to fuel sales, growth, and future earnings. Computer, biotech, and other innovative industries are better for growth investors. Keep reading for the scoop on stocks that work well for income investors.
Utilities generate a large cash flow. (If you don't believe me, look at your gas and electric bills!) Cash flow includes money from income (sales of products and/or services) and other items (such as the selling of assets, for example). This cash flow is needed to cover expenses, loan payments, and dividends. Utilities are considered the most common type of income stocks, and many investors have at least one utility company in their portfolio. Investing in your own local utility isn't a bad idea — at least it makes paying the utility bill less painful.
Note
Before you invest in a public utility, consider the following:
The utility company's financial condition: Is the company making money, and are its sales and earnings growing from year to year? Make sure the utility's bonds are rated A or higher (I cover bond ratings in the "Examining a company's bond rating" section, earlier in this chapter).
The company's dividend payout ratio: Because utilities tend to have a good cash flow, don't be too concerned if the ratio reaches 70 percent. From a safety point of view, however, the lower the rate, the better. See the "Looking at a stock's payout ratio" section, earlier in this chapter, for more on payout ratios.
The company's geographic location: If the utility covers an area that's doing well and offers an increasing population base and business expansion, that bodes well for your stock. A good resource for researching population and business data is the U.S. Census Bureau (
www.census.gov).
Real estate investment trusts (REITs) are a special breed of stock. A REIT is an investment that has elements of both a stock and a mutual fund (a pool of money received from investors that's managed by an investment company).
A REIT resembles a stock in that it's a company whose stock is publicly traded on the major stock exchanges, and it has the usual features that you expect from a stock — it can be bought and sold easily through a broker, income is given to investors as dividends, and so on.
A REIT resembles a mutual fund in that it doesn't make its money selling goods and services; it makes its money by buying, selling, and managing an investment portfolio of real estate investments. It generates revenue from rents and property leases, as any landlord does. In addition, some REITs own mortgages, and they gain income from the interest.
Note
REITs are called trusts only because they meet the requirements of the Real Estate Investment Trust Act of 1960. This act exempts REITs from corporate income tax and capital gains taxes as long as they meet certain criteria, such as dispensing 95 percent of their net income to shareholders. This provision is the reason why REITs generally issue generous dividends. Beyond this status, REITs are, in a practical sense, like any other publicly traded company.
The main advantages to investing in REITs include the following:
Unlike other types of real estate investing, REITs are easy to buy and sell. You can buy a REIT by making a phone call to a broker or visiting a broker's Web site, just as you can to purchase any stock.
REITs have higher-than-average yields. Because they must distribute at least 95 percent of their income to shareholders, their dividends usually yield a return of 5 to 12 percent.
REITs involve a lower risk than the direct purchase of real estate because they use a portfolio approach diversified among many properties. Because you're investing in a company that buys the real estate, you don't have to worry about managing the properties — the company's management does that on a full-time basis. Usually, the REIT doesn't just manage one property; it's diversified in a portfolio of different properties.
Investing in a REIT is affordable for small investors. REIT shares usually trade in the $10 to $40 range, meaning that you can invest with very little money.
Warning
REITs do have disadvantages. Although they tend to be diversified with various properties, they're still susceptible to risks tied to the general real estate sector. Real estate investing reached manic, record-high levels during 2000–2007, which meant that a downturn was likely. Whenever you invest in an asset (like real estate or REITs in recent years) that has already skyrocketed due to artificial stimulants (in the case of real estate, very low interest rates and too much credit and debt), the potential losses can offset any potential (unrealized) income.
Tip
When you're looking for a REIT to invest in, analyze it the way you'd analyze a property. Look at the location and type of property. If shopping malls are booming in California and your REIT buys and sells shopping malls in California, then hopefully you'll do well. However, if your REIT invests in office buildings across the country and the office building market is overbuilt and having tough times, you'll have a tough time, too. In 2009 and for the next few years, it will pay for investors to be extra selective regarding REIT investments because the difficulties in the real estate industry aren't over yet.
In recent years, the oil and gas sector has generated much interest as people and businesses experience much higher energy prices. Due to a variety of bullish factors, such as increased international demand from China and other emerging industrialized nations, oil and gas prices have zoomed to record highs. Some income investors have capitalized on this price increase by investing in energy stocks called royalty trusts.
Royalty trusts are companies that hold assets such as oil-rich and/or gas-rich land and generate high fees from companies that seek access to these properties for exploration. The fees paid to the royalty trusts are then disbursed as high dividends to their shareholders. By the first half of 2008, dividend-rich royalty trusts sported yields in the 9 to 15 percent range, which is very enticing given how low the yields have been in this decade for other investments like bank accounts and bonds. You can research royalty trusts in generally the same venues as regular stocks (see Appendix A).
Warning
Although energy has been a hot field in recent years and royalty trusts have done well, keep in mind that their payout ratios are very high (often in the 90 to 100 percent range), so dividends will suffer should their cash flow shrink.