The following blog post was submitted by Anthony Prams of www.smartfinancemag.com
As clear as it sounds dividend investing consists in buying stocks from companies that pay dividend. This concept can be seen as a conservative strategy due to the thorough stock picking process that needs to be done in order to successfully beat our benchmark. Dividends are part of the profits that are paid out to the shareholders. So in order to keep paying dividends a company needs profits. Some companies use all the profits generated to reinvest them and expand their activities to new markets or improve their position in the current markets, etc…Therefore, some companies don’t pay dividends. When a company reinvests the profits expects to increase their stock price by increasing the real value of the company. That is how investors make money out of these companies, exclusively by price increase of the stocks. This methodology is seen as risky by some investors because nobody knows how the market is going to react to the investments these companies make.
A conservative investor, in the stock exchange market, looks for companies that can offer a solid and stable flow of income to the portfolio during a long period of time. Conservative investors are recommended to use an attitude of “buy & hold” because in order to get the dividend you need to be holding the stocks at least during certain dates. Other strategies with a faster move of positions “buy & sell” wouldn’t allow the investor to plan the collection of the dividends.
Dividends are a privilege, not a right. This is something very important that needs to be understood. No company guarantees its dividends. Dividends are approved by the board of directors of the company annually and may decide at certain times to cancel the dividend to shareholders in behalf of the interests of the company. That is why a deep research of the company has to be made before buying any stock and decide whether or not to enter in that position at that time.
Unfortunately in the last years we have had many examples of partial dividend cuts or dividend cancellations on many companies from the S&P 500 index. Companies often use the dividend as an incentive to attract investors seeking a regular income. The problem arises when economic uncertainty looms, or when the company decides to allocate that cash dividend to acquire other companies, or even worse, when use those resources to finance its debt.
Chesapeake Energy (CHK) and Linn Energy (LINE) were forced to cancel their dividends few years ago. Two solid companies in the energy sector, totally unexpected. On the other hand Chevron (CVX) and ExxonMobil (XOM) have been increasing their payouts gradually because their competitive advantage has been kept above its competitors for a long time. Dover (DOV) and Procter & Gamble (PG) are the examples of two companies that have each updated their quarterly dividends for 60 consecutive years.
The danger for an investor chasing high dividend is the risk that the market is giving to those companies. There is always a reason… maybe the company is dealing with some turbulence and it is unclear if will be able to keep the dividend, either for sectoral reasons or particular reasons. But there is always a reason why a company offers a high dividend. The market never abandons a chance of making a profit.
As a general rule, we have to be skeptical with stocks offering profits twice plus one the average of the index in dividend return. For example, if the average dividend rate of the S&P 500 is 2%, then all companies with dividends above 5% will be considered too risky for a conservative portfolio. If it is higher than 5% probably that stock has been penalized by the market for any reason and there is an intrinsic risk it needs to be considered before buying the stock.
If diversification is important in any type of investment when applying dividend investing it is even more important. The reason is that an investor seeking for dividend usually needs that regular income to maintain his living standards. Or people who are investing their life savings. Or just a saver that wants to build up a savings fund as a private pension. So they cannot afford to lose that money. By diversifying into different stocks in different sectors, the portfolio will be protected against any structural problems that at any given time can be in a specific sector, like the Oil sector nowadays; where cuts or cancellations on that dividend won’t affect the whole performance of the portfolio. Not all sectors suffer in the same way economic turbulences, there are always some less affected than others.