Investors have many choices these days to create income in their portfolios. One way to do so is to buy dividend stocks, especially from companies that increase their payouts over time. But what are dividend stocks?
"Dividend income is often overlooked amid gyrations in the stock market," writes John Eade, president and director of Portfolio Strategies at Argus Research. "But dividends are an important element of return." And as such, they can help soften the blow during periods of market uncertainty like we saw in 2022, when the Federal Reserve began aggressively hiking interest rates to bring down inflation.
Here, we answer the question "what are dividend stocks," and look at how do they differ from bonds or interest paid in a money market funds. We'll also go over where investors can look to find the best dividend stocks.
How does a dividend stock work?
Companies are legally able to pay out a portion of either their income or their retained earnings. These payments are called dividends.
Preferred stock sets the actual dollar amount to be paid out each period based on the par value of the security. But for common stock, or "ordinary" shares in overseas markets, dividends are determined on a monthly, quarterly, semi-annual or annual basis. The board of directors sets these payments.
In the U.S., public companies tend to pay out a portion of earnings that are level or consistent each quarter. Then, each year, the board of directors will often increase the payout, usually on an incremental basis.
One advantage of keeping dividends level and growing over time is that it can help stabilize the stock price.
Note that bonds and interest from money market funds or CDs are different from dividend stocks. With these asset classes, the investor knows exactly how much each payment will be made.
Considering rising interest rates lower the price of a bond, which, in turn, boosts its yield, these fixed-income assets have been an attractive option for investors in 2023. However, when interest rates fall, bond yields do too – so it's something to be aware of once the Federal Reserve begins cutting rates.
As for dividend stocks, investors know the yield of their stock based on the annualized rate that the company is forecast to keep paying. Over time, the dividend can grow, and this means the dividend yield could rise, and vice versa.
Are dividend stocks a good buy?
For the most part, investing in dividend stocks is a good thing. For one, they have been shown to boost total returns (price return + dividends) over time.
"Since 1926, dividends have contributed approximately 32% of total return for the S&P 500, while capital appreciations have contributed 68%," writes S&P Dow Jones Indices in its study on the importance of stable dividend income. "Therefore, sustainable dividend income and capital appreciation potential are important factors for total return expectations."
However, as with anything in investing, there are risks associated with dividend stocks. One of the main pitfalls is buying shares in a company that can't afford to maintain its dividend. If the company's earnings have been consistently falling, chances are good that it will have to eventually lower its dividend.
For example, in early 2022, AT&T (T) – long known as one of the best dividend stocks on Wall Street – slashed its annual dividend by over 46%, to $1.11 per share from $2.08. This was part of a complicated spinoff plan between AT&T and Discovery that created Warner Bros. Discovery (WBD).
However, Warner Bros. Discovery does not pay a dividend. So, while at the time of the spinoff, existing AT&T shareholders received 0.24 WBD share for each T share they owned, they were also left with much lower income as a result of the dividend cut. To make matters worse, AT&T’s stock price has fallen by more than 20% since early 2022.
Another potential pitfall is only seeking out stocks with high dividend yields. "[A]n unusually high dividend yield can actually be a warning sign," writes Dan Burrows, senior investing writer at Kiplinger.com, in his article on S&P 500 stocks with highest dividend yields. "That's because stock prices and dividend yields move in opposite directions. It's possible that a too-good-to-be-true dividend yield is simply a side effect of a stock having lost a lot of value."
Additionally, with some corners of the market like real estate investment trusts (REITs), dividend payments, or "distributions," are falsely high. This is because REITs combine dividend payments with return of capital payments. In other words, they pay out a portion of their paid-in capital.
How to find the best dividend stocks
The main advantage of adding dividend stocks to your portfolio is their ability to accelerate your total return over time through steady growth of their payouts. For example, let's say that a company pays out $3.00 per share and the stock price is $100.00.
That means its dividend yield now is 3.0%. But if the company raises the dividend by 20% over the next three year period, the investor is now making $3.60 per share.
Now the yield to the investor is 3.6% (i.e., $3.60/$100), which can help increase the total return. Say, the stock has gained 10% on the year, but including the dividend yield, the total return for the investor is 13.6%.
Bond payments don't rise over time as they are set as coupons. The same is true for CDs. Money market funds can be volatile when their interest payments rise and fall quickly. But with stable dividend stocks, investors can experience higher income over time. This is based on the underlying earnings power of the company.
As such, investors will want to seek out high-quality dividend growth stocks, and what better place to start than with the Dividend Aristocrats. To be included on this list, a company must have raised its payout at least 25 straight years. There are also the Dividend Kings, which have increased their dividends for a minimum of 50 consecutive years.
Mark R. Hake, CFA, is a Chartered Financial Analyst and entrepreneur. He has been writing on stocks for over six years and has also owned his own investment management and research firms focused on U.S. and international value stocks, for over 10 years. In addition, he worked on the buy side for investment firms, hedge funds, and investment divisions of insurance companies for the past 36 years. Lately, he is also working as Chief Strategy Officer for a tech start-up company, Foldstar Inc, based in Princeton, New Jersey.
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