How Investors Get Dividends and Growth

How Investors Get Dividends and Growth

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To understand how generous a stock has been over time, investors must nail down the interplay of dividends and price. (Getty Images)

Investors seeking dividend-paying stocks are generally drawn by the promise of steady income. But if things go well, the shares go up, too, building up a portfolio before retirement or keeping it going long after the investor has stopped working.

If that is the goal, what should the investor look for?

Many advisors stress that dividends and growth are both part of something that matters more than either by itself – total return, the gain in value that comes from dividends plus growth. Dividends are convenient for investors who want a regular income, but it doesn’t pay to focus on them exclusively.

“Today we can buy a lot of consumer, health care and telecom names with yields over 3 or 4 percent, selling at price-to-earnings multiples in the low double digits,” says Jim Wright, chief investment officer at Harvest Financial Partners in Paoli, Pennsylvania. “Those same companies will probably grow their earnings and their dividends at a low- to mid-single digits rate. If they can do that, we expect an attractive total return.”

[See: 7 Monthly Dividend Stocks for Steady Income.]

So dividends and price gains both matter. Clearly, it would be silly to choose a stock with a 3 percent dividend but flat price over one with no dividend but 10 percent gains every year. You could buy the second stock and sell 3 percent of the stake to generate the same income and still be ahead.

“Don’t forget that great growth companies typically don’t pay dividends,” says James E. Demmert, managing partner at Main Street Research, a wealth management firm in Sausalito, California. “Fast-growing companies, in fast-growing sectors, typically do not pay dividends. These companies prefer to use the cash to re-invest back into the business, fueling greater future growth. Technology and biotech are just two examples of sectors that typically provide no, or very low, dividend yields.”

And the interaction between dividends and price can pose real hazards for investors who chase yield, seeking the biggest dividends they can find. Dividend yield is total dividends paid over the previous 12 months divided by current share price. If the share price falls by half, the yield will double.

“Don’t be fooled by high yield alone,” Demmert says. “Stocks that have higher-than-average dividend yields often are signs of a troubled company.”

The interplay of dividends and price is also key to understanding just how generous a stock has been over time. Investors often favor stocks with strong average annual returns over periods of three, five or 10 years, hoping that indicates strength that will continue. But this data assumes that all dividend payments were used to buy more shares. The investor who spends dividends will earn less over time by not purchasing those additional shares.

And in the long term that can be a big hit, because shares bought with reinvested dividends pay dividends themselves, allowing even more shares to be purchased. The effect snowballs so that over the years more and more of the holding is attributable to dividend reinvestment.

While many good companies pay no dividend, dividend payers have often outperformed non-payers, according to research by Heartland Advisors, which runs a fund emphasizing small-cap dividend stocks. From 1928 through the end of 2017, non-payers had annual returns averaging 8.6 percent, while the lowest dividend payers averaged 9.1 percent and the highest (by quintile) 10.75 percent, the firm says.

“From 1960 through 2016, $10,000 invested in the S&P 500 would have grown to almost $400,000 if you had spent the dividends along the way,” says Eric Wightman, partner at the XML Financial Group has offices around the District of Columbia. “But had you reinvested those dividends and let them compound you would have over $2.1 million now.”

Since many factors can muddy the picture when the investor goes looking for dividend payers, experts recommend focusing on a few key factors:

Price matters. An investor seeking income might conclude that it doesn’t matter if the share price dips from time to time so long as the dividends keep coming. That may be true for routine fluctuations, but price indicates the company’s health and prospects, and a falling or volatile price can be a sign of trouble that could eventually cause a dividend cut or suspension, or lead to a capital loss if the shares must be sold – for an emergency or to buy a better investment, for instance.

[See: 7 of the Best Dividend Stocks to Buy for 2018.]

Kevin Dixon, senior trading analyst at Market Traders Institute in Orlando, Florida, favors stocks that show price gains after dividends are paid, as many stocks dip due to the reduction in cash on hand following a dividend payout.

To further narrow the candidates, “I look for stocks that are trading within 10 percent or so of 52-week highs,” he says.

It’s still a stock. Though dividend income may be the goal, choosing the stock requires the same analysis one would do in seeking growth.

“There is great value in having a part of your portfolio in dividend-paying stocks, but make sure that the company is on solid financial footing,” Demmert says. He prefers companies with a history of raising dividends. Dividend aristocrats are stock that have raised dividends annually for at least 25 years.

Demmert also likes companies recovering from a downturn, such as energy firms today. They offer a strong dividend yield at current prices plus potential capital gains as shares rebound, he says.

He cautions, however, that things can go wrong for dividend payers as with any other stock. Rising bond yields, for instance, could draw investors away from dividend payers, undermining prices.

Also revealing is the dividend payout ratio, or percentage of earnings paid in dividends, says Alexander S. Lowry, director of the financial analysis program at Gordon College in Wenham, Massachusetts. Cash not paid out can be reinvested to grow the business, so a very high payout ratio may suggest the firm has run short of ideas or opportunities, or might have to cut the dividend if earnings dip.

“As a rule of thumb, I like to see companies in this category maintain a payout ratio of less than 50 percent, Lowry says. “That offers enough breathing room for the company to survive an economic downturn or a slump in sales without needing to reduce its dividend payment.”

Be agile. While it’s usually bad to sell in a panic when things go wrong, it’s also risky to overdo the practice of waiting out downturns. If the stock has tanked or the directors have suspended the dividend, it may be time to get out.

[See: 9 Dividend Aristocrats for Stable Income.]

As with any investment, the key question is not whether the stock has been a winner or loser in the past, but what you think it will do in the future, experts say. Even a winner is a candidate for sale if the future isn’t so bright. Ask, “Would I buy it today?” If not, sell. If you would, keep it.

Top Large-Cap Dividend Stocks

Stock Name Dividend Yield 1 Year Return
WPP ADR WPP 3.63 805.19%
Ecopetrol ADR EC 2.78 144.20%
Valero Energy Corp VLO 2.36 104.15%
Kohl’s Corp KSS 3.57 81.20%
T Rowe Price Group Inc TROW 2.19 75.19%
Intel Corp INTC 2.1 60.31%
Phillips 66 PSX 2.69 59.62%
Marathon Petroleum Corporation MPC 2.25 58.71%
BHP Billiton ADR BBL 4.76 57.28%
CNOOC ADR CEO 2.95 55.84%

Stock information as of June 4th, 2018

Tags: money, investing, income, stock market, bonds