An income with your capital gain, the best of both world’s
Dividend investing is a popular investing strategy which uses fundamental analysis in order to determine a company’s ability to pay a dividend reliably.
Dividend investing is an income investing strategy and the primary goal of the dividend investor is to receive an income stream, rather than a capital gain. The basis for this strategy is to purchase shares in a dividend paying company at an attracted price, thus providing a desired yield on the capital invested.
Only good quality dividend paying companies with a history of increasing revenue and producing a profit are considered, as dividend investing requires the company to continue to pay the dividend well into the future.
An example of a dividend paying stock is AmTrust Financial Services, Inc. NASDAQ:AFSI with its fundamental data shown below in Table 1.
Fundamental Data: AFSI
|Book Value $/share
Referring to Table 1. above, the dividend has increased every year over the last five years. Also the company has increased its revenue every year over the last five years. While the earnings has dropped over the last year it’s still significantly higher than five years ago. The ROE (return on equity) is quite good and the company continues to expand its workforce with the number of employees increasing. This financial information shows that AmTrust Financial Services, Inc. is in pretty good shape fundamentally and is likely to continue paying dividends into the future.
Dividend investing tends to somewhat go out of vogue during strong bull markets, as the capital gains made from growth stocks can be irresistible to investors. During these buoyant times, the investors that continue with dividend investing tend to be investors that are very risk adverse.
Dividend investing is generally considered one of the lowest risk strategies for investing in the stock market. The mere fact that dividend investing seeks out only those companies that are fundamentally sound and pay generous reliable dividends means that most stock candidates tend to be older mature companies that have been in business for quite a long time, and as such the risk of these companies running into financial difficulties is relatively low.
One issue the dividend investor needs to keep in mind is that of interest rates. In a low interest rate environment, it is not difficult to find good quality stocks with dividend yields higher than the interest rates that can be obtained from a bond. However, in a high interest rate environment, the dividend yield available may well be less than that obtained from bonds or even bank interest rates.
This then leads to another issue when interest rates are high; a dividend paying stock’s price will still appreciate in the long-term in line with economic growth, whereas the principle value of bonds remains unchanged. That is, at the expiration of the bond the bond s only value is the interest income, whereas a dividend paying stock offers both the dividend income and some long-term capital growth.
In addition, the dividend payment per year increases over time in line with the company’s profits increasing over the long-term. Thus the effective dividend yield per year actually increases over the long-term based on the original capital invested, whereas a bond’s interest payments remain static rather than increasing over the long-term. The article Dividends and Coupon Payments compares the payments received from a dividend paying stock and treasury bonds over the last decade.
One of the main criticisms of dividend investing is that the dividend yields are very low during strong bull markets. This is primarily due to the fact that stock prices can increase more rapidly than the companies’ profits (and thus their dividends) during a strong bull market.
Basically there are two ways for the dividend investor to obtain a reasonable dividend yield.
Firstly is to purchase stocks that pay reliable dividends but without any significant growth prospects as these companies do not need to reinvest their profits to finance any growth. Utility companies and manufacturing companies tend to have limited grow potential and as such have no requirement to finance any significant expansions. Thus they tend to pay out a large portion of their profits as a dividend.
Secondly is to wait for the stock price of a low dividend yield company to drop to a level where the dividend yield is attractive. Generally the stock’s price will only drop low enough when some event caused investors to sell out, which could be anything from a company reporting less than expected profits, to a generally poor economic environment. Dividend investors make good use of bear markets to top up their portfolios with quality dividend paying stocks that have been sold down heavily and are now paying decent dividend yields.
Historically, the stock’s price of most dividend paying companies at some point will drop to level that will provide a decent dividend yield and this is where dividend investors add these stocks to their portfolio.
At some point the stock price will drop low
enough to provide a decent dividend yield
Reliable dividend paying stocks do not generally include growth stocks. However they can still provide good long-term capital growth in line with the growth in the economy which when combined with the dividend income can provide a respectable return on the capital invested.
The characteristics of a good dividend paying stock include the following.
Characteristics of good dividend stocks
- Fundamentally sound with a history of reliable revenue, profits and paying dividends.
- Mature companies that have been in business for quite some time are best. Newer companies that have been in business for only a couple of years have not yet proved their reliability.
- Generally are not growth companies as they tend to reinvest their profits.
- Low dividend yield companies can provide decent dividend yields when they are out of favor as the stock prices are now sufficiently low to provide a decent yield.
- Typically, both the current and forecast PE ratios are low.
- Insiders such as directors and key employees purchasing shares rather than selling shares. These insiders know the company and their own buying provides confidence that the company is fundamentally sound.
Good dividend yields can be obtained when the stock’s price has been declining. This makes some stock investors nervous as investors tend to be more comfortable buying a stock when its price is climbing rather than falling. The main point here is to check that the dividend paying stock is still fundamentally sound.
While dividend investing is not as popular nowadays as it was in the past, this style of investing still has a significant following with its relatively low risk being one of its main attractions along with a regular cash payment income stream. Combine this with some long-term capital growth and it’s not difficult to see why risk adverse investors are still attracted to this investing strategy.
Dividend investing is generally suitable for buy and hold portfolios and most dividend investors rarely ever sell a stock. They will typically add to their portfolio when a stocks price drops to a level where its dividend yield becomes more attractive.
The added bonus that the dividend investor enjoys is that the dividend income per year increases over the long-term in line with growth in the economy, thus the dividend yield actually increases over time based on their original capital invested.