Judging by my twitter feed over the past year dividend investing seems to be the only way to achieve financial independence. Is relying on company dividends a sure-fire way to financial freedom?
What Are Dividends?
A dividend is a small amount of money paid out by a company to shareholders. The dividend is seen as a way of rewarding the shareholders for investing their money (or time) into the company.
Some companies choose not to award dividends but rather reinvest the money back into the business.
Some companies choose to pay out dividends which are clearly over the odds. This is often as a way of “bribing” people into investing into the business. If you see a company with an extremely high dividend you have to ask yourself why? Is there not anything they can do to grow the business utilising that capital?
What is Dividend Investing?
Dividend investing in it’s simplest terms is the use of capital to invest in companies that pay out a regular dividend.
There are a few things an investor will look for when choosing a suitable company to buy into.
- A long history of dividend payouts
- A reasonable dividend payout percentage
- Future outlook for increasing dividends
Some companies have a long history of paying out dividends, stretching as far as decades into the past. Once a company has a long streak of dividend payments or even dividend increases they will go out of their way to continue the streak even if they did not make a significant profit for the most recent period.
An example of this would be Gannet (owners of USA today) They currently pay out 234%, meaning they give away more money than they actually make.
Dividend Payout Percentage
The amount of money a company decides to payout can be expressed in a purely financial terms e.g $0.25 per share. This means if an investor has 100 share they would receive $25 dollars.
Alternatively and more commonly, the dividend will be expressed as a percentage. E.g the share is valued at $100 and the dividend is $2 the percentage is 2%.
A share percentage is more useful for understanding the benefits of each investment.
|Company A||Company B|
In this example Company B looks like the clear winner, however if we look at the percentages a different picture may emerge.
|Company A||Company B|
|Value Of Holding||$200||$200|
It’s now become clearer that company A offers a better dividend return.
When investing for dividend the last thing you want to do is put a significant amount of money into a company if the future does not look particularly rosy.
Large companies cutting shares in late 2015 early 2016
|Company||Date Dividend Cut|
|Glencore||6th September 15|
|Standard Chartered||3rd November 15|
|WM Morrison||9th November 15|
|J Sainsbury||4th January 16|
|Rolls Royce||7th February 16|
|Rio Tinto||11th February 16|
|Anglo American||16th February 16|
|Centrica||18th February 16|
Looking into a company’s possibility for growth going forwards can be considered as important as looking back to the past. Can the company continue to grow shares in the current trading environment.
Any example in the future could be a fossil fuel based company (coal or oil). They may have paid out dividends for 60 years but could the demand reduce so substantially over the next 10 years that they can no longer pay a dividend?
The Problems with Dividend Investing
So after all you’ve just read, what could possibly be wrong with dividend investing. After all a company gives you money multiple times a year direct into your bank account. It sounds too good to be true.
Missing Out On Growth
It will come as no great surprise to you that share prices have gone up and down through history but always eventually moving in an upward trend.
S&P 500 – 90 Year Historical Chart
Extremely large companies the type that pay out consistent dividends tend to grow significantly slower than small companies that are on a growth trajectory.
By investing specifically for dividend payout early in your investing career you could miss out on a significant amount of capital growth.
|Company A||Company B|
|Total Value Year 10||$1,628.89||$1,346.53|
Company B has only given you 55% of the profit of Company A
Imagine you invest in company B because you like the look of the dividends, you decide to automatically reinvest the dividends until you decide to retire. You follow this pattern for twenty years. At that point the market drops and due to some sub prime mortgage failure in the “United States of Somewhere”.
The markets drop 50% and your investment is only valued at $906.57. The same thing happens but this time you are invested in Company A; Your investment is still worth 1326.65.
Now before the naysayers make the claim that you wouldn’t have to sell your shares and so wouldn’t need to solidify the loses. That’s great but it’s difficult to plan how you will react when half of your life savings suddenly disappears.
As Mike Tyson famously stated “ Everybody has a plan until they get punched in the face”
Never in the history of the stock markets have so many people extolled the benefits of dividend investing.
It has been a perfect storm over the past 5 years. Interest rates across the globe have dropped further and further. In some cases governments are offering negative interest rates.
Putting money in banks in the hope of some day retiring simply doesn’t work anymore.
More and more media outlets began discussing the benefits of dividends. People who have never considered the stock market are becoming over night “expert investors”.
The stock market has begun heating up again. P/E (price per earnings ratio) has started rising. We are not yet at the P/E levels of early 2009 (P/E 70.91) or early 2002 (46.17) but it is creeping up.
The longer interest rates stay low the further the stock prices will rise. The higher prices rise the lower the dividend percentage will become.
So we have discovered the benefits of dividends, receiving money from a company on a regular basis is great. That cannot be denied by anybody.
However as we have seen above investing strictly for dividends can limit the growth of your investment. Utilising a total returns investment strategy i.e. share growth + dividends is the only sensible option.
If you are interested in reading more about my investments then take a look a look here .