For an investor who wants steady income as well as growth, investing in dividend stocks can fill the bill. There are quite a few companies that have paid increasing dividends without a break for decades. There are even companies that have not missed a dividend payment for more than a century. This short list includes companies that have been paying dividends for more than 120 years!
- Exxon Mobile
- Johnson Controls
- Coca Cola
- Colgate Palmolive
- Consolidated Edison
- Procter & Gamble
- York Water
- Eli Lilly and Company
- Stanley Black and Decker
(List courtesy of The Motley Fool)
A common misconception is that dividend stocks are not growth stocks. However, over five and ten year time frames the best-paying dividend stocks usually outperform the S&P 500 by several percent! Dividends are sign that a company is making money with its business plan and dividends paid over a long time provide proof that their business plan is sound. When considering intrinsic stock value, steady and increasing dividend payments are a plus. But, before investing in dividend stocks, an investor should learn the basics of these investment vehicles.
Dividend Stock Introduction
The reason that so many investors have dividend-paying stocks in their portfolios is that they like the steady payments. However, most investors, during their earning years, reinvest their dividends through automatic dividend reinvestment plans. With these plans there is commission or fee to pay and the vast majority of plans allow for the purchase of fractions of shares. The investor will pay taxes on these dividends but will have growth of their number of shares as well as the growth of the stock price. When an investor reaches retirement, they will typically stop reinvesting their dividends and simply enjoy the quarterly check.
Investors like companies that not only paid dividends year after year but also increase those dividends over time. The companies know that a large segment of their investors expect this and, as such, the company will manage its finances in such a way as to continue the same practice over the years, decades, and longer.
Companies that pay dividends are typically stable and as such are attractive to long term buy and hold investors. These folks may be mature investors looking to beef up their retirement income or younger investors who are patiently building wealth over the years.
What Is a Dividend?
Dividends are payments, usually paid quarterly, to shareholders of a company. The money comes from company profits, after taxes. Dividends are commonly paid by mature companies that have moved past their initial phase of rapid growth. The company has a big share of its market and will need to create new products and services through R&D to grow more. Thus, the company pays dividends to compensate its investors for its now-slower growth. Companies that commonly pay high dividends are utilities (power companies) which are very stable, have slow growth, and lots of money.
Investing in Dividend Stocks
An easy way to start investing in dividend stocks is to use a stock screener. Generate a list of stocks with the highest dividend rates and companies that have steadily increased their dividends over the last 5, 10, 15, or 20 years. It is important to look at the longer term when picking dividend stocks because long term dividend payments are a sign of the company’s financial strength while temporarily high dividends are often used by companies in trouble in order to artificially jack up their stock price.
Once you have picked a few promising dividend stocks it is time for fundamental analysis. This is another step in making sure that the company offers growth as well as dividends and that its business plan is likely to continue driving profits and increasing dividends into the distant future.
Selling Dividend Stocks
When a previously profitable company starts to lose market share and profits, they may continue to pay the same dividend even when their share price is falling. Thus, the dividend may look great, but when you look closely at the company you will see trouble brewing. As with all long term investing, when you are investing in dividend stocks, it is wise to periodically reassess your portfolio and discard any that no longer fit your criteria.
Dividend Reinvestment Plans
No brokerage fees
There are several advantages of reinvesting your dividends via a dividend reinvestment plan (DRIP). When you sign up for the DRIP with your dividend stock, you will not pay any brokerage fees when you reinvest dividends. And, if you choose to buy a few more shares with cash on hand, those shares can also be purchased without brokerage fees.
Except when you want to purchase extra shares, you can ignore your DRIP and simply let the company do the work of calculating shares and fractions of shares that will be added to your account every quarter.
An often-overlooked feature of dividend reinvestment plans is that shares may be discounted by up to ten percent! And, this discount commonly applies to extras shares that you purchase as well.
With a dividend reinvestment plan an investor will see a compounding effect in his investment. Dividends create more shares and those shares create dividends. This effect on your investment can be substantial with a company that pays a healthy dividend, increases it regularly, and pays dividends for decades at a time.
Downsides of Dividend Reinvestment Plans
As your investment grows with your DRIP it can be like a dream come true. But, don’t forget to pay taxes on those dividends. Actually, this part is not so bad because the company administers the DRIP and will send you a year end statement of taxable earnings.
But, when it comes time to sell any of your dividend stock, it can be a pain sorting out the base cost of all the various parts of your dividend reinvestment plan in order to pay long term capital gains. And, when a stock price is volatile, an investor may wish to buy or sell in a timely manner. But, with the dividend reinvestment plan purchases are made when the company wants to make them which, in theory, will not be when you wanted to. This takes us back to the start when you are picking dividend stocks. Avoid stocks with high dividends but poor financials. Choose the stalwarts that have been paying healthy dividends for decades without fail and which have stable but growing stock prices.
For more insights regarding developing a dividend yield strategy, follow the link.