On the surface, the concept of “dividend investing” seems like a very straightforward idea. Invest in companies that make distributions, reinvest those dividends regularly, and slowly accumulate wealth over the long run. In reality, however, implementing a successful dividend income strategy for your portfolio is far from an easy task.
Investors need to know what factors to consider, which ones to avoid, and how to spot stocks that look great on the surface but are in the process of crumbling. Below, we take a look at some of the common misunderstandings about dividend investing, and offer up some truth behind the misconceptions.
Utilities and Telecoms Are the Only Reliable Sources of Dividends
This misconception comes from the idea that only mature industries pay reliable dividends. In the past, many mature and stable dividend-paying companies were utilities and telecommunication companies. But in the 21st century, there are established companies of every size in practically every industry that are paying dividends.
For example, in the consumer tech space, as of November 2012, Microsoft (MSFT) had a 3.2% dividend yield and Apple (AAPL) had a 1.9% dividend yield. For more proof, look at Intel (INTC) and IBM (IBM). These companies do not have the 100-year track record that Coca-Cola (KO) has, but they certainly will not be gone tomorrow.
Abbott Labs (ABT) is another prime example. This company focuses on pharmaceuticals, medical devices and nutritional products, and sells these products in more than 130 countries. Abbot Labs (ABT) had a 3.1% dividend yield as of November 2012. Energy producer ConocoPhilips, an international integrated energy giant, had a dividend yield of 4.7% in November 2012.
High Yield Is Always a Good Thing
The statement above is simply not true. Dividend yield is calculated by taking the dividend per share and dividing it by the price per share. The lower the price per share, the higher the dividend yield will be. Thus, a sharply falling stock price is often the reason behind a high yield.
There is often a very good reason for this, and it can be because the fundamentals of the business are weak and investors are staying away. Look at Nokia (NOK) as an example. This company has paid a dividend every year since 1989; however, as of November 12, 2012 Nokia was losing $300 million per month and its dividend yield was at 9.8%. This is even after slashing its dividend in half over the past four years. This just goes to show that high yield may very well mean high risk.
Investors should look at the underlying reason why a stock has a high yield before making any investment decision. The last thing you would want is for the dividend to get cut when you least expect it.
MLPs Are Risky Dividend Sources Tied To Energy Prices
In recent years many investors have flocked to Master Limited Partnerships, or MLPs, as sources of attractive dividend yields. But many have hesitated to utilize this asset class due to concerns that the impact of energy prices will result in extreme volatility in stock price.
MLPs generally generate cash flow by transporting and storing energy commodities such as petroleum and natural gas — they operate the pipelines that get fuels across North America. But these entities aren’t as vulnerable to swings in gas prices as many would suspect; becase they generate fee-based revenues MLPs actually have access to very stable income that doesn’t fluctuate with spot prices. Essentially, these companies operate toll roads that collect fees regardless of how much the vehicle passing through costs.
Dividend Investing is Equivalent to Value Investing
This misconception comes from the fact that value investors try to find stocks that look cheap, valuation-wise, while dividend investors are looking for stocks trading at low prices in comparison to the dividends. Though these methods are similar, they are not the same. The difference is that one is concerned with capital gains while the other is interested primarily in dividend income.
Value investors are interested in finding stocks trading at a discount to the company’s intrinsic value. This takes into account future cash flows, risks, growth and other factors over a period of time. Value investors look for a low price-to-earnings ratio, price-to-growth and price-to-book, among other ratios. The goal is to implement a margin of safety to overcome any errors in these assumptions and capitalize on the capital gain afterward. This is where the saying “Buy Low and Sell High” originates. Many value investors will be attracted to stocks that have never paid a dividend, or that have little prospect of making a cash payout anytime soon.
Dividend investors, on the other hand, may consider a completely different range of factors. While they’re also drawn to stocks that are cheap compared to the intrinsic value, there’s an increased emphasis on identifying businesses with sustainable cash flows over the long haul. Yields and payout ratios are more of a concern, as are the odds of dividend increases in the future.
Dividend Stocks Are Always Safe Stocks
This is not always true, and recent history has given us many examples of dividend-paying companies falling on hard times. While many investors have made money with dividend-paying stocks, there are others that have lost money by paying attention just to the dividend yield and not to the health of the company. Just during the past few years there have been plenty of examples. For instance, take General Motors, Bank of America (BAC), Citigroup (C), and Barnes and Noble were all dividend paying stocks that suffered collapses of one type or another in the past five years. And the list goes on; though these companies offered stable dividends at one time or another, it didn’t mean that they were immune from industry and financial changes. Learn more about some of the biggest dividend disasters of all time.
The Bottom Line
Stocks in general can be volatile and companies can post huge losses. The key is finding a reliable industry to invest in with a long track record of consistently increasing its dividend and paying dividends. Even with this in mind, investors should do their due diligence in case the tides should turn against them. Warning signs include increasing dividend yields and underlying fundamental issues with the business. High dividend payout ratios, especially those above 100%, are also cause for concern (although payout ratop doesn’t apply to certain stock types like REITs and MLPs). The more you know about your investments, the better, so be sure to avoid the misconceptions outlined above. Your portfolio will thank you.