Dividend investing is a type of investment strategy and philosophy that mainly concentrates on income-generating investments. A dividend investor believes that dividends have a significant role to play in the overall returns received by shareholders. This approach is based on the idea of being a part-owner of a company that is eligible to receive a portion of the profits in the form of dividends. Also known as income-investing, this strategy focuses on both generating income and achieving capital appreciation.

TABLE OF CONTENTS:

What is a Dividend Investor?

Dividend investing is a popular strategy that leverages the power of compounding long-term distributions along with capital appreciation. I’ve observed that investors who adopt this philosophy usually fall into two categories.

The first category includes income-hungry investors who need a steady income source, and dividends provide a great form of passive income. This group often includes retirees looking to supplement their income in their golden years, or those looking to achieve financial freedom at any age through passive sources of income.

The second category is made up of dividend investors who believe in the power of compounding and often adhere to a dividend reinvestment plan. They aim to compound dividends with capital appreciation over long time horizons. This “Dual Compounding” effect of adding back all dividends in combination with the rise in share price turbocharges overall returns.

If we observe the chart below of the ASX 200 and look at the price return and then the overall return (Including Dividends) we can see the important role that dividends have in overall returns.

The dividend investing strategy focuses on identifying stable and consistent companies with attractive dividend yields. It’s often overlooked by investors who prefer a more active approach, such as value or growth investing.

The dividend strategy is best suited for investors who prioritize income over capital gains and typically adopt a buy-and-hold strategy.

How does Dividend investing work?

When considering a dividend investment strategy, investors typically start with three factors – the Dividend Yield, the Dividend Payout Ratio, and the stability of the dividend over time.

For investors seeking income, such as retirees who rely on dividends to draw their income, stability is the most important consideration. A higher yield may not always be the best option, as it could be based on an undervalued stock or a cyclical company experiencing a boom period.

Dividend Yield

Dividend Yield represents the income return on an investor’s capital. For example, if you own one share valued at $100 and a company pays a $5 dividend, the dividend yield is 5%. While yield is significant, a slightly lower yield that is reliable in the future is always better than a slightly higher yet unstable one. Sometimes a company will raise the yield to make it look attractive to draw shareholders in. However at the first sign of trouble, they cut it.

Payout Ratio

The Payout Ratio is the dividend amount paid out as a percentage of a company’s earnings. For example, if a company pays $2.50 in dividends and earns $10 per share, the payout ratio is 25%. This factor is crucial because investors want to ensure that the company has enough funds to continue operations while still paying a consistent dividend. If the payout ratio is too high, the company may have little to reinvest into growing, and it may struggle during financial hardship, with the dividend being the first thing to go.

Stability of the Dividend

The Stability of the Dividend is the most vital aspect for those seeking dividends as a source of income. Investors should look for companies with a track record of paying consistent dividends with slight increases in yield over time. If a dividend reinvestment strategy is a priority, investing in higher-yield companies that pay relatively new dividends can still work well as there is more time for compounding.

To understand stability investors need to look at the payout ratio and the yield in combination. If the payout is lumpy and the yield has not been consistent then it may be a concern long term. The management can also be heavily incentivised to “draw out cash” which may not be in the best interests of shareholders.

Reinvesting to Boost Total Returns

In a simplified example, imagine that you owned 1 share of a company which was valued at $100. Over the course of the year, the value of the share increased by $10 to $110. Additionally, the company paid a dividend yield of 5%, which amounted to $5. This means that your total return would be 15% ROI if you reinvested everything. A Dividend Reinvestment Plan (DRP) is a method where instead of receiving the $5 dividend in cash, you receive it in the form of more shares.

The powerful effect of reinvesting dividends in a company that is also growing can turbocharge returns.

It’s essential to invest in mature, stable companies with a long history of paying dividends, attractive yields, and a payout ratio that balances growing the business and rewarding shareholders.

Companies with high dividends often cut the dividend in tough times. They also tend to have higher payout ratios, which leaves less room for financial challenges. It is better to look for companies that are increasing their dividends over time while demonstrating a rising yield in combination with growing free cash flow and earnings. That is why growth and stability are so important. These companies also attract Quality Investors due to the the stability and “quality” behind the company.

Why do Stocks pay out dividends?

A dividend is a portion of the company’s earnings paid out to shareholders, usually because of a surplus of profits.

Paying out Dividends is a form of Capital Allocation. Companies that generate positive earnings and free cash flow have several options to allocate capital to.

They can either reinvest all the free cash flow back into the business, usually at higher rates of return than the cost of capital. Companies invest in expansion, R&D, Marketing, innovation, capex, and other value-adding investments (hopefully).

They can also allocate capital to share buybacks, which is a form of rewarding shareholders by reducing the amount of shares on the public float. To be successful at this strategy one needs to buy the shares back at the right price.

A company may choose to let the cash sit on the balance sheet and pile up. This often attracts activist investors if left too long as it often doesn’t reward shareholders.

Or the company can choose to declare a dividend and issue the earnings back to shareholders. Sometimes dividends are declared because a company is in a mature stage, earning a lot of free cash flow and has little room left to reinvest the earnings. In this case, it is best delivered back to shareholders.

Companies that have a consistent and growing dividend signal to shareholders the financial strength and durability of the business.

What are the pros and cons of being a Dividend Investor?

There are several pros and cons of adopting the Dividend investing strategy as a Philosophy. I have listed a few reasons for each to help investors get a wider picture of whether this is the right investing style for them.

➕ PROS	➖ CONS
Great form of Passive income and can provide a steady source of income with little or no work.	Taxation: Dividends are taxed as income unless franking credits are applied (Thanks Australia)
Dividend Reinvestment is a great long term compounding strategy that works.	If dependent on income dividends may not be guaranteed. Need to be sure if a dividend is cut you can survive.
Investing in a growing company that pays dividends rewards you twice. Income + Capital Appreciation.	Sometimes the payout is too high and the stock may not perform as a result. Holding a losing dividend payer is not a great strategy.
Can provide stable income if investors pick quality dividend companies.	High Dividend payouts are risky and can cause a capital loss as the share price retracts.
Dividends can be less volatile than the stock market as a whole.	Overall returns may not be as high by chasing a dividend yield. Picking income over a high growth opportunity.
Quality dividend paying companies are usually low risk safer options.	High yielding dividend traps. Companies can be undervalued and poor businesses to hold.
Can be a great inflation beater if companies increase the yield over time.	Hard to cut dividends without a drop in share price.

How to consider the Dividend investor approach in your Philosophy?

Investors who adopt the dividend investment style should consider what they want to do with the distributions. They can reinvest into the business with a DRP, reallocate the cash to other stocks or asset classes, or draw the cash out and use it.

For investors looking for growth in a short period of time, dividend stocks may not be the right fit. The Dividend strategy is more popular among long-term investors.

If you’re seeking a source of stable income to fund a financially free life, you’ll need a decent chunk to start with. For instance, if you need $50,000 in passive income, you’d need about $1.2m invested earning yields of between 4-5%.

The benefits of dividend income are apparent when interest rates are low and bond returns don’t match what high-yielding companies can provide. However, when rates and bonds are providing the same risk-free returns, one needs to consider the added risk a dividend company may pose. Although there may be some loss in capital appreciation, if income stability is crucial, then limit all downside.

However, if a dividend investing strategy is of interest as a long-term wealth builder, then the strategy will be different. A dividend investor needs patience and discipline to stay the course with a long-term horizon, just like all other investment strategies.

Anyone in the accumulating stages of wealth creation can implement this type of reinvestment dividend strategy. Allow compounding to work. If you draw dividends out, you disrupt the power of compounding and the dual-earning strategy. The dividend strategy is more geared towards less active investors who have other things to do than actively monitor holdings. This is not to say that it is a set-and-forget, but once you select some high-quality dividend aristocrats and reinvest all dividends, there is little to do.

What are the Characteristics of Dividend stocks?

Whether you are looking to invest for the long term or need an immediate income source, picking high-quality dividend companies should be the goal. I believe that investors should focus on quality over quantity. A handful of Dividend aristocrats is far greater than a collection of average dividend payers.

• Consistent dividend payout history. (Think in years not in months)
• Strong dividend growth rate – NOT just high yield.
• Solid financial fundamentals. Healthy balance sheet.
• A Competitive advantage that reinforces stability.
• A payout ratio that is sustainable and allows the business to grow.
• Healthy cash flow and profitable earnings.
• Mature and less volatile companies.
• Dedicated management aligned with rewarding shareholders.
• Usually have a dividend growth yield greater or in line with inflation.
• Pays out of profits and cash NOT Debt.

In Summary…

Dividend investing can be a great option for many investors when combined with a diverse portfolio. Although I am not a dividend investor in my active strategy, I do hold dividend-paying ETFs in my retirement fund, which have been compounding very well over time.

Even though I don’t actively seek out dividends, I still hold companies that pay dividends, but my preference is for companies that reinvest their capital at a high rate of return. Paying out dividends generally means that these companies are running out of room to expand, but this is not always the case.

Small-cap investors like myself sometimes hold great businesses with plenty of room for growth, profitability, and increasing free cash flow. Issuing dividends can attract new shareholders and reward existing ones. To strike a balance between growth and reward, I usually look at the payout ratio, and no more than 20% is a good threshold.

Sometimes smaller companies have management with significant inside ownership. Such management is aligned with shareholders and doesn’t take large salaries. In such cases, issuing a dividend can be a way to reward management for the effort they put in.

One benefit of holding a small-cap that pays dividends and continues to scale is that the yield is on the original capital outlay, and that yield can skyrocket the longer you hold it. Picking growth companies that pay out smaller payout ratios and holding them can be an excellent way to build capital over time.

As you go through different investment stages, you may want to start decumulating, and you can then convert the DRP into cash payouts. I believe as I get older and my needs change I may shift to a dividend investor and start to draw the cash out…maybe!