Investing In Dividend-Paying Stocks

Investing In Dividend-Paying Stocks

Investing In Dividend-Paying Stocks: A “Strong Buy” Since 1935

by Martin Denholm, The Smart Profits Report
Thursday, October 23, 2008: Issue #875

Fear and greed dominate the stock market. While they’re always prevalent, they become magnified in times of great stress – like now. Smart investors know better than to base their investment decisions on emotions like these.

When it comes to investing, the ability to play solid defense can ease you through turbulent times much better than most ordinary investors.

And the concept here is simple: Defensive investing means having some strong, dividend-paying stocks in your portfolio. Forget running to cash as a “last resort” because of negative market performance.

Instead, it’s better to look for long-term drivers – like earnings growth, cash and the ability of companies to pay dividends to their shareholders. In fact, history shows us that this is a particularly smart way to go. From 1935 to 2007, more than 40% of the S&P 500′s total return came from reinvested dividends.

The beauty of dividend-yielding stocks is that they work well in both rising and falling markets. During the bull market of 1982 to 2000, dividend stocks actually outperformed non-dividend payers by a considerable margin, despite the underlying share price appreciation.

And in volatile, sinking markets like we’re experiencing now, it’s comforting to know that you still have a source of income throughout the madness. You’re essentially being paid for your patience, rather than selling off like everyone else. Let’s take a look at some of the other benefits of dividend-paying assets.

The Benefits of Investing in Dividend-Paying Stocks

The benefits of investing in dividend-paying stocks are numerous. Here are three that we feel are most important:

• Lower Your Average Cost: When you’re receiving a regular dividend payment, and reinvesting those shares, over time it reduces the price you originally paid. It’s essentially like buying a house, then renting it out to offset the payment and pick up income, while the underlying asset appreciates at the same time.

• Stability During Downturns: When the broader stock market is under pressure and share prices are falling, stocks that pay dividends are often considered one of the “safer haven” investments, since investors are still receiving income. In turn, it’s good PR for a company, with the stock attracting more investors and the share price potentially rising as a result.

• Get Management on Your Side: When a company is regularly distributing money back to its shareholders, it requires management’s discipline and long-term planning to keep that outflow consistent. Knowing that dividend payments must be met reduces the chances that they’ll fritter your money away. If they pay out too much, or invest in risky projects, they risk impacting their ability to pay a dividend. In many ways it can be the ultimate “check” on a management’s work.

The Pitfalls to Investing in Dividend-Paying Stocks

Of course, there are pitfalls when it comes to investing in dividend-paying stocks too. Here are three things to look out for:

• Beware Dividend Reductions: If a company reduces or suspends its dividend payments, it’s usually done as a last resort. Management recognizes that changing dividends results in an immediate negative reaction from shareholders. It could signal that the company is having trouble raising cash, or that the business is making less money.

• Consider Tax Implications: Naturally, the IRS wants to take its piece of the pie – and when it comes to dividends, it’s a double-whammy. First, it claims the regular corporation taxes from the company. Then, when the company passes what’s left down to its shareholders, those investors are then taxed on what they receive. In addition, the Jobs Growth and Tax Relief Reconciliation Act – which lowered the tax rate on dividends – expires in 2010, so we may see dividend taxes rise when it does.

• Question Growth Ability: Some argue that while companies should be praised for rewarding shareholders through dividends, it may also mean that it can’t find other investment options or projects. Generally larger companies return part of their profits in dividends when their growth slows.
  

Ultimately, dividend-paying stocks need to be thoroughly researched, like any investment. But adding them to your portfolio could be just the answer to defending your bottom line.

Good investing,

Martin

Today’s Investment U Crib Sheet

Dividend yields are based on two things – the price of the stock and the amount of the dividend payment. As share prices drop, dividend yields rise. So wild fluctuations in a stock price can artificially inflate yields. And bargain shoppers are often drawn to these low-priced, high-yielding stocks. But beware.

A company that yields significantly more than the industry averages could be a dividend “trap.”

For example: A company trades at $10 a share and yields a respectable 7%, paying 70 cents. If that share price drops by 80% (as much of the market has done recently), the yield jumps to 35%. Many investors are lured by this “bargain.”

But when the company lowers its dividend, the resulting exodus from fleeing shareholders leads to a lower stock price. The bargain shoppers find themselves trapped with a stock that’s worth much less than what they paid for it, and a company that pays out much less than they thought they were getting.

So beware of high dividend rates. It pays to do your research. Take a look at dividend history, cash flow, and a company’s ability to continue paying income before you invest.

Recently, Alex Green warned us about dividend traps and how we can avoid them in Investment U Issue #816, As Bank Stocks Fall… Beware of the Dividend Trap.