Getting a grip on dividends and dividend rates

When people talk about gaining income from stocks, they’re usually talking about dividends. Dividends are pro rata distributions that treat every stockholder the same. A dividend is nothing more than pro rata periodic distributions of cash (or sometimes stock) to the stock owner. You purchase dividend stocks primarily for income — not for spectacular growth potential.

Dividends are sometimes confused with interest. However, dividends are payouts to owners, whereas interest is a payment to a creditor. A stock investor is considered a part owner of the company he invests in and is entitled to dividends when they’re issued. A bank, on the other hand, considers you a creditor when you open an account. The bank borrows your money and pays you interest on it.

A dividend is quoted as an annual dollar amount (or percentage yield) but is usually paid on a quarterly basis. For example, if a stock pays a dividend of $4 per share, 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. If the company continues to do well, that dividend can grow over time. A good income stock has a higher-than-average dividend (typically 4 percent or higher).

Dividend rates aren’t guaranteed, and they are subject to the decisions of the stock issuer’s board of directors — they can go up or down, or in some extreme cases, the dividend can be suspended or even 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.

Recognizing who’s well-suited for income stocks

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, whereas 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.

Given recent economic trends and conditions for the foreseeable future (I give you the heads-up on many of them for 2020–2030 in Chapter 25), I think that dividends should be a mandatory part of the stock investor’s wealth-building approach. This is especially true for those in or approaching retirement. Investing in stocks that have a reliable track record of increasing dividends is now easier than ever. There are, in fact, exchange-traded funds (ETFs) that are focused on stocks with a long and consistent track record of raising dividends (typically on an annual basis). ETFs such as the iShares Core High Dividend ETF (symbol HDV) hold 45–50 companies that have raised their dividends every year for ten years or longer. HDV paid a dividend of 24 cents in 2011, and that dividend went to 82 cents in 2019 — a 241 percent increase in eight years. Similar ETFs are available and can be found at sites such as www.etfdb.com (use search terms such as “high dividend,” “dividend growth,” or “dividend yield” to find them). Discover more about ETFs in Chapter 5.

Assessing the advantages of income stocks

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.

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 higher concentration of them in these industries. For more details, see the sections highlighting these industries later in this chapter.

Heeding the disadvantages of income stocks

Before you say, “Income stocks are great! I’ll get my checkbook and buy a batch right now,” take a look at the following potential disadvantages (ugh!). Income stocks do come with some fine print.

Pinpointing your needs first

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 — a better choice may be to invest in growth stocks because they’re more likely to grow your money faster over a lengthier 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 $100,000 left to invest, you need a portfolio of income stocks that yields 5 percent ($5,000 divided by $100,000 equals a yield of 5 percent; I explain yield in more detail in the following section).

You may ask, “Why not just buy $100,000 of bonds (for instance) that may yield at least 5 percent?” Well, if you’re satisfied with that $5,000, and inflation for the foreseeable future is 0 or considerably less than 5 percent, then you have a point. Unfortunately, inflation (low or otherwise) will probably be with us for a long time. Fortunately, the steady growth of the dividends that income stocks provide is a benefit to you.

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 and investing resources.

Checking out yield

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.

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 will continue to perform indefinitely. Monitor the company’s progress for as long as the stock is in your portfolio by using resources such as www.bloomberg.com and www.marketwatch.com (see Appendix A for more resources).

Looking at a stock’s payout ratio

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 = sales – expenses). Keep in mind that companies pay dividends from their net earnings. (Technically, the money comes from the company’s capital accounts, but that money ultimately comes from net earnings and capital infusions.) Given that, the company’s earnings should always be higher than the dividends the company pays out. An investor wants to see total earnings growth that exceeds the total amount paid for dividends. 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 (or net income) 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) are $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, plenty of room still exists to pay dividends.

If you’re concerned about your dividend income’s safety, regularly watch the payout ratio. The maximum acceptable payout ratio should be 80 percent, and a good range is 50 to 70 percent. A payout ratio of 60 percent or lower is considered very safe (the lower the percentage, the safer the dividend).

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.

Studying a company’s bond rating

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) and Moody’s are the major independent rating agencies that look into bond issuers. They look at the bond issuer and ask, “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.

• If a bond rating agency lowers the rating, that means the company’s financial strength is deteriorating — a red flag for anyone who owns the company’s bonds or stock. A lower bond rating today may mean trouble for the dividend later on.

• 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.

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 medium grade, and anything lower than that is considered poor or very risky (the bonds are referred to as junk bonds). So if you see an XXX rating, then … gee … you better stay away!

Diversifying your stocks

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 risk.

It’s electric! Utilities

Public utilities are among the stock market’s most reliable dividend payers. They generate a large cash flow (if you don’t believe me, look at your gas and electric bills!). Many investors have at least one utility company in their portfolio. Income-minded investors (especially retirees) should seriously consider utilities — and there are great utilities ETFs as well (see Chapter 5 for more on ETFs). Investing in your own local utility isn’t a bad idea — at least it makes paying the utility bill less painful.

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 (see the earlier section “Studying a company’s bond rating”).
• 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 earlier section “Looking at a stock’s payout ratio” 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).

An interesting mix: Real estate investment trusts (REITs)

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.

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 90 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 (REITs are more liquid than other types of traditional real estate investing). You can buy a REIT by making a phone call to a broker or visiting a broker’s website, just as you can to purchase any stock.
• REITs have higher-than-average yields. Because they must distribute at least 90 percent of their income to shareholders, their dividends usually yield a return of 5 to 10 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.

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.

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 you’ll probably 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.

Many of the dangers of the “housing bubble” have passed, and investors can start looking at real estate investments (such as REITs) with less anxiety. However, choosing REITs with a view toward quality and strong fundamentals (location, potential rents, and so forth) is still a good idea.

Business development companies (BDCs)

For those seeking a relatively high dividend with some growth potential, consider taking a look at business development companies (BDCs). They sound a little arcane but they can be bought as easily as a stock, and their setup is not that difficult to understand. A BDC is essentially a hybrid between a venture capital company and a mutual fund, and it trades like a closed-end fund. A closed-end fund functions like a regular mutual fund, but it is listed in the same way as a stock and has a finite number of total shares. Regular mutual funds are referred to as “open-ended,” which means that their shares are issued (or redeemed) and there is no finite number of shares as with closed-end funds.

Like a venture capital firm, a BDC invests in companies that are small or mid-sized and that need capital to grow in their early stages of development. A BDC is like a mutual fund in that it will invest in a batch of companies so there is some sense of diversification. The companies that the BDC invests in tend to be in a particular niche such as biotech, robotics, or another “sunrise” industry. As part of the financial structure, the companies receiving the funding from the BDC pay back the financing through higher fees and interest, so BDCs tend to have a high dividend.

Given that, a BDC can provide good dividend income, but keep in mind that there is higher risk since the companies are still in the early stages of development. For more details on BDCs, check out resources such as the following:

• CEF Connect (www.cefconnect.com)
• Closed-End Fund Advisors (www.cefdata.com)
• Closed-End Fund Association (www.cefa.com/)

As of this writing, there are now 49 BDCs, so there is more information on them in traditional stock investing resources (see Appendix A for more details).