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Why Dividend Investors View Stocks Differently
Intuitively, you would think that everyone cares about the price of stocks that they own. After all, no one like to lose money, right? Who likes to see the market go down?
Well, one category of investors cares a lot less when their stocks go down: Dividend investors.
Dividend investors focus on the dividend–and especially its growth–far more than they do on the stock’s price.
Investors in strong dividend-paying stocks are doing just fine in 2008. Hundreds of millions of dollars have been distributed to dividend stockholders this year, and they will continue to be paid every month and every quarter.
But this cash reward from dividend stocks is ignored by most of Wall Street and the financial media. There is no “Dividend Index” reported minute-by-minute the way the Dow, NASDAQ, and S&P 500 are reported.
But those are all price indexes. They reflect price changes only and therefore give an incomplete picture of “how stocks are doing.” After all, total returns (the ultimate goal of every investor) are made up of price returns plus dividends. Price indexes such as the Dow do not reflect dividends.
Dividends are stocks’ secret weapon. They operate in the background. They are not sexy enough to get much attention. They don’t involve IPOs, takeovers, “the next big thing,” or making millions in a couple of weeks.
But dividends are extremely important to total returns. They should not be ignored. According to Morningstar, S&P 500 companies have grown their dividends at a 16% annual clip for the past three years, 12% in the past 12 months. If there were a Dividend Index based on the S&P’s 500 stocks, it would be up 9 to 10% this year.
So dividend investors focus on increasing dividends as much or more than the stock’s price. Two main metrics for dividend investors thus become: (1) initial yield at time of purchase, and (2) dividend growth rate.
As to initial yield, according to Morningstar, the dividend yield on the S&P 500 right now is 2.6%, which is higher than it has been in a few years. (That yield has been inflated by the general drop in stock prices this year.) Many stocks, of course, yield much more than 2.6%. Reasonable minds can differ as to what an acceptable minimum initial yield should be for a dividend stock. I set a floor of 2.5% (or 1.9% for stocks with an uninterrupted 25-year history of dividend growth). Others may set other floors, such as 4%, to stay even with or ahead of inflation right from the moment of purchase. The point is, each investor can set his or her own minimum acceptable dividend yield as part of the stock selection process.
As to dividend growth, the key number is the rate of increase in the annual money-per-share paid to stockholders. The best dividend companies increase their dividends every year like clockwork. Many have done so for decades, without a freeze or a cut. My personal minimum growth requirement is 5% (as demonstrated by the average of the last three years). I’m sure that many dividend investors demand a higher minimum. Again, the important point is that you can set your own standard, and then look for stocks that meet or beat it.
My Easy-Rate(TM) point system for evaluating dividend stocks awards higher scores for both greater initial yields and faster rates of growth than my minimums. So I would never buy a dividend stock with both an initial yield and historical dividend growth rate right at my two minimums. Either one or the other would have to be higher for me to consider purchasing the stock.
The two measures–initial yield and rate of growth–are essential to a good dividend-stock selection process, along with your normal fundamental checks for company soundness.
There are plenty of solid dividend-paying candidates. Here are just a few examples (all figures from Morningstar as of 9/2/2008):
–Abbott Laboratories (ABT): initial yield 2.4%, 3-year growth rate 7.4%
–Coca-Cola (KO): 2.8% and 10.8%
–GlaxoSmithKline (GSK): 4.7% and 5.4%
–Kinder Morgan Energy Partners (KMP): 6.5% and 6.5%
–Sunoco Logistics (SXL): 7.3% and 12.7%
As stated earlier, the best dividend companies increase their payouts every year or nearly every year. Dividend increases mean that the yield on your original investment goes up over time. (That is, the “current yield” stated in the newspaper or online does not apply to you any more, just to new purchasers.) At an average annual increase of:
–6%, your dividend doubles about every 12 years
–10%, every seven years
–12%, every six years
–15%, every five years
Now it is certainly true that many dividend-paying companies have not escaped the bear market. Indeed, some of them-the financials-have been especially hard-hit. Dividend-paying stocks are not immune from market risk.
But the really committed dividend investor does not care as much about this–which is the exact point of this article. The committed dividend investor becomes accustomed to varying principal, and cares little more about it than a bondholder cares that his or her bond trades on the open market at varying prices. The investor is focused instead on the cash the investment is bringing in. In fact, if the dividend investor is not using that cash as current income, but is instead accumulating assets to fund a future goal such as retirement, he or she sees price drops as an opportunity to purchase more shares at better prices and yields than before.
That does not mean that dividend investors never sell. But they are probably less likely to sell than investors focused on capital appreciation alone, because dividend “disappointments” are pretty rare in well-selected dividend stocks. Dividend investors’ reasons for selling may include a cut in the dividend; a slowing in its growth rate; or a chance to swap for a higher-yielding stock or one with a faster-growing dividend.
Dividends and dividend-paying companies have lots of positive attributes. Here are my top six:
1. Dividends are cash in your pocket. You can re-invest that money in the company, or in another company, or nowhere. You can spend it.
2. You do not have to sell a share of stock to get it. They credit it to you each month or quarter.
3. Most dividend programs are persistent. Companies with well-established programs rarely cut or eliminate their dividends. Many have uninterrupted, decades-long histories of paying and raising dividends. It is their ability to do this that separates them from “fixed income” investments like bank accounts and bonds.
4. Studies show that over long periods, dividend-paying stocks have had the highest total returns of all. According to Ned Davis Research, from 1972 to 2006 (a period that includes the tech bubble, when dividends contributed little), non-dividend-paying stocks gained an annual average return of 4.1%. But dividend-paying stocks returned 10.1%, an enormous 6%-per-year difference. Wharton Professor Dr. Jeremy Siegel’s research showed that 97% of the stock market’s return from 1871 to 2003 can be traced to re-invested dividends.
5. Dividends are closely watched and reported, so information about them is easy to obtain. Over time, companies establish dividend patterns that are consistent. Significant changes in the pattern are reported instantly.
6. If you build a strong portfolio of dividend-paying stocks that regularly increase their dividends, you can arrive at retirement with a significant income stream paying an enormous yield on your original investment. You may be able to make a transition from a salary paycheck to a “dividend paycheck” seamlessly.
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