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Dividend Investing - Starting with the Basics

October 22, 2015 | Team Kalkine
Dividend Investing - Starting with the Basics

Dividend stocks

These are the stocks that produce a regular stream of income for shareholders from companies who distribute a portion of their profits to shareholders much in the same manner as companies pay interest to bondholders or banks pay interest to depositors. They produce a steady stream of passive income which investors can use to spend or to reinvest in other forms of investments. This makes the dividend stocks particularly attractive to investors such as retired people who are looking for income to support their regular living expenses. They also have certain characteristics which make them attractive investments.
 

Benefits of dividend investing

Dividend paying companies are normally more mature and stable because they are in a position to distribute a part of their profits. Start-up companies normally do not pay dividends because they have to retain their profits to finance growth. Only when a company achieves the level of success that is sustainable on a consistent basis will the directors choose to pay a dividend so that they are able to justify themselves to shareholders on a continuing basis. This also means that they are less prone to risk taking because the dividend needs to be sustained. This also has the effect of reduced volatility of stock prices which means that prices do not decline as much when the markets are declining. Of course, the flip side of the coin is that prices may not rise as much when the markets are rising.
 
Naturally, investors can benefit from rises in stock prices as well as from the regular income stream, and one can benefit from companies that do not pay dividends only by selling the stock whereas a steady stream of dividends enables investors to enjoy some of the benefits while retaining ownership of the stock. Moreover, dividends can produce a hedge against inflation by compensating investors for some of the losses caused by inflation in the value of other investments such as bonds or deposits. It may happen that an inflation rate of say 2% per annum can reduce the yield on income investments other than stocks from a nominal rate of say 10% per annum to 8% per year. Moreover, even in flat or declining markets, dividend paying companies continue to maintain the dividend and may even partially offset the drop in stock prices.
 

Reaping more through the magic of compounding

Dividends offer investors the chance of taking advantage of compounding by generating income from their stock investments and allowing them to reinvest the income stream in more stocks to generate earnings from their dividend earnings. The effect of reinvesting the dividends by buying more stocks has the effect of increasing the dividend earnings without digging into your own pockets. The effect of the time value of money can be pretty dramatic in the context of compounding when you consider that the more often you receive and reinvest your dividends, the higher the eventual rate of return on your investments.
 
Some companies thus also offer a dividend reinvestment plan (DRIP) that facilitates investors for reinvesting cash dividends automatically through the purchase of additional or fractional shares on the dividend payment date. This makes the most out of the compounding technique.
 

Selecting the appropriate stocks

Great investors often base their investing strategies at least partly on the basis of dividend investing because depressed economic conditions in particular tend to result in lower interest rates often mean that the only way to benefit is to select stocks with large dividend yields. There are often some common characteristics in the stocks which are to be picked. For instance, businesses with long corporate histories often going back decades or centuries are often favoured. These companies often have the knack of not surprising investors with unpleasant events because they have an extensive knowledge of their businesses and how to manage them. They also know exactly how to change their businesses and reinvent them to cope with the changing demands of technology and the changes in consumer behaviour. For instance, there have been no radical changes in the way Coca-Cola and Wal-Mart establish the fundamentals of their businesses. It is also much easier to predict the ability of generating cash flows in the future for such well-established companies and therefore much easier to predict the sustainability of the dividend. After all, one of the keys to dividend investing is the ability to select companies which produce sustainable and predictable income streams year after year in the long term.


Woodside Petroleum Dividend over the years (Source: Company Reports)

Few such good examples include Woodside Petroleum Limited (ASX: WPL) that has a strong balance sheet and annual dividend yield of 9%; National Australia Bank Limited (ASX: NAB) that has exhibited strong FY 2015 and is associated with annual dividend yield of 6.24%; and Flexigroup limited (ASX: FXL) that has annual dividend yield of 7.04%. In fact, companies like WPL are considered to be healthy as they try to pay consistent and rising dividends each year that help generate consistent cash flow.



Even small cap companies like Mortgage Choice Limited offer good dividends at the back of good performance and strong financial statistics.
 
Another characteristic is the ability to pick companies with a long-term competitive advantage though this is much easier said than done. There are only a few companies in this position that can reliably and predictably sustained this advantage year after year for many years to come. In fact, a good example is the information technology industry where failure to predict the next big thing can often lead to extinction in the short-term. Bill Gates of Microsoft has been quoted as saying that Microsoft is only two years away from extinction at any point in time and this is arguably one of the most successful companies for investors in the history of stock investing. For instance, Wal-Mart has grown to become the largest retailer in the world and the sheer scale of their operations allows them to get the best possible terms from suppliers to provide them with major competitive advantages. In turn, they are able to offer the lowest possible prices to their customers and provides them with unbeatable sales growth.
 
Finally the father of value investing Benjamin Graham perfected the concepts and techniques of finding businesses which were undervalued and trading below the true value of their businesses. Moreover, if this discipline can be combined with high quality businesses, the result will almost certain to be a successful investment. This can sometimes be found in stocks which have a low price/earnings ratio. You can also sometimes find this in companies where the stock price has been punished by the market for one-off events which are unlikely to recur. Sometimes this may involve substituting your native common sense for the perceived wisdom of the market but if you have good grounds for your decision, you are effectively lowering the risk of your investment.
 
All in all, it is best to stay tuned to track records of companies, weighing risk metrics versus financials, and peeping into features such as annual dividend yields statistics and DRIPs, and pick the ones that look most attractive. There is no particular thumb rule for investing as it is an interplay of multiples and not dependent on any single feature. For instance, sometimes even a high dividend yield can turn out to be an abnormal one if its ratio to free cash flow is skewed.
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