6 Reasons Why Dividend-Paying Stocks Are a Wise Investment

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Posted by The Savvy Retiree on October 30, 2019 in Investing

We have a word down in south Louisiana, where I grew up: lagniappe (think “lan-yap”). It’s a French Creole term that basically translates into “a little something extra.” Like, you go into a donut shop and order a couple of chocolate-glazed with a coffee, and the owner throws in a few donut holes just because you’re a regular customer. That’s lagniappe.

Wall Street has a form of lagniappe too. But they call it dividends. They’re a little something extra you get for buying certain companies. And in my way of long-term, buy-and-hold investing, they are a primary consideration when looking for stocks to own.

Across the long history of Wall Street, dividends have played a starring role in the creation of wealth. That’s because dividend-paying stocks don’t behave the same way as other stocks. They offer consistent payouts, they can weather economic storms, they outperform other stocks in a down market, and they signify quality, even in a market rife with speculation.

1. Dividends are a primary source of wealth creation. Without dividends, the Standard & Poor’s 500 stock index generated a return of about 4.8% a year since 1900, basically on par with staid bonds.

Throw in dividend payments and the return doubles to about 9.5% a year.

In the last few decades, dividends have fallen out of favor, replaced by share-buybacks and the use of corporate cash for mergers and acquisitions. Still, dividends have proven the better path. Between 1999 and the middle of 2018, the Dow Jones U.S. Select Dividend Index was up roughly 9% a year on average, while the S&P 500, which offers a minimal dividend yield, was up barely 6% a year.

That doesn’t seem like much. But, over a two-decade span, it’s the difference between turning $100,000 into $320,000 and turning it into $560,000.

2. Dividends provide an ongoing, stable source of income. The best dividend-paying companies pay dividends on a consistent basis, and, better yet, consistently increase their dividend payments from quarter to quarter or year to year.

That means if you own solid, stable dividend stocks, you can supplement your income and use your dividend payments to cover monthly bills or to fund hobbies and holidays.

What to Look for in Dividend Stocks

Just because a company pays a dividend doesn’t mean it’s a good company to own. Companies regularly cut or eliminate their dividend payments, a sure sign of a company in trouble.

What we want are dividend superstars: companies that we feel confident will not only continue paying dividends but will regularly increase their payments to us over time.

If a company hits these three targets below, then chances are you have found a worthy dividend candidate.

History: We want so see dividend payments that go back at least a decade, preferably longer. This tells us that management sees dividends as a crucial part of the company’s value proposition for shareholders.

Consistency: We want a company that consistently pays a dividend and, likewise, consistently raises the dividend payment over time. Again, proof of management’s focus on creating true shareholder value. We don’t want to see dividend cuts intermingled with dividend increases—that’s a sign of instability.

Payout ratio: The per-share dividend payment should be lower than a company’s earnings per share. We do not want a company that routinely pays dividends that are larger than its net income. That’s an unstable situation. Look for a payout ratio of roughly 70% or less. (If a company earns $1 per share, you want to see a dividend payment of no more than about $0.70 per share.)

3. Dividend-paying stocks consistently outperform in down markets. We already know dividends are the better option in up markets. But research shows that in years when the broader market is down, dividend-paying stocks are typically down less than 10% on average, while stocks that don’t pay dividends are down more than 20% on average.

The reason is that the stability of the dividend payment acts like a support mechanism. Investors recognize that a company that continues to generate the profits necessary to pay its dividend is a worthy investment, so when stocks are falling, they flee companies that pay no dividends and start snapping up the shares of companies that do pay a dividend. The demand for the stock then supports the share price.

Consider the most recent bear market between 2007 and 2009. While the S&P 500 lost basically 50% of its value over the 17-month period, a few exceptional companies performed markedly better. McDonald’s fell less than 3%. Walmart was up more than 7%. Healthcare companies such as Johnson & Johnson, Universal Health Realty Income Trust, and Baxter International were down between 6% and 29%. And companies that sell consumer-product staples, such as tobacco giant Altria and breakfast-table staple General Mills, fell between 12% and 21%.

Yes, most of those were down… but they were down far less than the overall market. Plus, their declines do not include the 17 months of dividend payments received along the way, which lessened the pain.

4. Dividend stocks are a hedge against volatility. Finance professors at the University of Wisconsin found in their research on stock-market volatility that, “Dividend-paying stocks, on average, are financially stronger than non-dividend paying firms, and have lower market risk exposures.”

What this means in practical terms for us as investors is that dividend-paying stocks are typically less volatile than other shares, so they are not bouncing around as greatly when the stock market is going nuts.

They are more stable…calmer. That gives us a greater sense of financial security when markets are heaving.

5. Dividends are a sign of quality. Companies that have a long history of paying dividends—especially a long history of ever-increasing dividends— tend to be some of the highest quality companies on Wall Street.

These days, it’s all too easy for a company to futz with its financial results to paint a picture of corporate health that may or may not be so accurate. But a company cannot fake a dividend payment.

The money lands in your brokerage account, or arrives as a check in the mail, and serves as tangible proof that some level of corporate profits is real. And real profits that result in a long, unbroken string of dividend payments are a sign of a high-quality company selling a product or service with long-lasting consumer demand.

6. Dividends are a sign of a healthy future. Corporate boards of directors only approve dividend payments because they are confident about the business going forward. If tomorrow looks iffy, or if the board knows that trouble exists, their first action is to preserve cash by cutting or eliminating the dividend payment.

So, when a company consistently pays a dividend, it shows us that their business is stable and growing, that the shares we own aren’t likely to fall out of bed, and that the dividend payments we rely on will continue well into the future.

At this point you are, no doubt, thinking to yourself, “That’s all fine and dandy, Jeff. But what are those companies?”

Well, truth is, a good dividend stock today is different than tomorrow. The quality of the company doesn’t change, but the dividend yield very well might. By that, I mean that a great company offering a dividend yield of, say, 5%, is a much better investment than that same company with a yield of, say, 2%.

In the former case, the yield is enticing…in the latter case, the yield has been pushed down because excessive investor demand for the shares has driven the stock price higher. I do not want to buy even the best company at an excessive price. I would much rather own that company at a fair price and get a fair yield.

The best way to know that is compare a company’s current yield with its typical yield over the last five or 10 years. If the yield today generally reflects the company’s historic yield, you’re buying the shares at a generally fair price.

But if the yield today is dramatically lower, then you can bet that investors have rushed into the stock and driven its share price up, meaning you’re paying a premium to own the stock…and that’s not the best way to invest.

That said, if I were to guide you toward high-quality, fairly-priced dividend stocks today, I’d tell you to look at companies like these five:

Southern Company, a utility provider across 19 mainly southern states, yielding just over 5% as I write this.

Realty Income, a real estate investment trust (REIT) operating shopping centers dominated by retailers and services providers such as Dollar General stores, Walgreens, and FedEx— the kinds of companies for which demand is largely inelastic. Its current yield is just under 5%.

Universal Corp., one of the world’s primary growers of tobacco and a supplier to major tobacco retailers. Nearly 1 billion smokers in the world today (the number is growing, not shrinking) burn through nearly 18 billion cigarettes every day. Universal is a winner in that, helping explain why the company has paid increasing dividends every year for almost half a century. Its current yield is 5.3%.

Oneok, own pipelines, processing facilities and storage centers that connect natural-gas liquids to major metropolitan hubs. It’s basically a natural-gas utility that has been in business for nearly 115 years. Its current yield is almost 5%.

Universal Health Realty Trust, a REIT like Realty Income, but focused on healthcare assets. Given America’s aging demographics, that’s a sector we want long-term exposure to as investors. The company has increased its dividend payment every year since its founding in 1986. Its current yield is 4%. And there you have it: high-quality, stable companies offering you a little lagniappe for owning their shares.

Where to Find Dividend Income

Not all industries are fertile when it comes to dividend payments. But there are some where dividends flow more freely, and in greater volume. These are four industries where you want to look for the best and often most-stable dividend payers:

Master Limited Partnerships: MLPs generate income that flows, untaxed, to the holder of partnership shares. For that reason, MLP yields tend to be very high, and generally fairly stable. Most MLPs operate in the energy sector, running petrochemical pipelines, oil and natural-gas fields and the like. Yields are often 4% to 10% or more. But beware: Too much MLP income inside an IRA (more than $1,000 a year) can trigger tax issues.

Real Estate Investment Trusts: REITs function similarly to MLPs in that their income flows untaxed to the shareholder. So, REITs often offer quite high yields. The companies own and operate all sorts of real estate, ranging from office towers and shopping centers to apartments, medical facilities, hotels, and nursing homes. Yields are typically 3% to 9% or more.

Consumer staples: Think about the everyday items you have to buy: food, beverage, health and hygiene products, medicines, basic clothing. These are consumer staples—the items we purchase no matter what’s going on in the economy. Yields are typically 2% to 6%.

Utilities: The companies sending electricity, natural-gas, and water to homes and offices. They aren’t as stable as they used to be before deregulation, but they’re still very good dividend-payers to own. Yields are typically 2% to 8%.

Written by Jeff Opdyke