By FPA member Scott Hughes, CFP®, MBA
Last Updated: October 31, 2011
In today’s turbulent market, why not rent out your portfolio — yes, rent out your portfolio!
Okay, maybe that’s not entirely possible.
However, just as a landlord counts on income from tenants, stock investors can look to high-quality dividend paying stocks to receive rent — in the form of quarterly dividends — while waiting out today’s market volatility.
On a daily basis, the media tells us how the markets have shifted or what stock has gone up or down and by how much. However, that information may not be critical for you if you have a longer term time horizon. Realistically, the daily gyrations of the markets have little long-term implications for most investors.
A retiree who is seeking income, or an investor looking for some definitive return from their portfolio, should consider all components of total return.
Just as a landlord would not check the value of his investment property every day, calm investors in high-quality dividend paying stocks can relax more than speculators trying to make fast trades and quick dollars.
What are the two main components of total return?
- Capital Appreciation: Capital appreciation provides headline sizzle and as such, is bantered about frequently with reports of “The stock market gained/lost today,” or “XYZ Company reported earnings and saw their stock go up/down today.” It’s the same story day after day with the media alternating the words gained/lost and up/down where appropriate. But is that really the whole story? For many it is not.
Dividends: Income paying stocks can provide cash (like rent) to an investor on a quarterly basis. Historically, dividends have played a large role in an investor’s total return. In fact, up until the early 1980’s, dividends were a primary driver when considering whether or not to buy a stock. Over the last three decades, dividends have given way to capital appreciation. However, some experts think that the pendulum may swing back to dividends being the more important factor to consider when choosing a certain stock.
How much of a role have dividends played historically?
From 1926 to 2010, the average rate of return of the S&P 500 was 9.6 percent. Surprisingly, dividends have come in at almost half of that return at a respectable rate of 4.1 percent per year.1
In today’s environment, the S&P 500 is currently paying a dividend yield of about 2.0 percent. Yet, it’s not hard to find investments that focus on high-quality dividend paying stocks that could boost your dividend yield to three percent or more. If you would prefer not to pick those stocks on your own, you can find quite a few mutual funds and ETF’s (Exchange Traded Funds) that focus exclusively on dividend paying stocks.
In a climate where you might be lucky enough to earn 0.25 percent on your bank savings account, earning a dividend yield of 3.0 percent would be a vast improvement — assuming you have the time, are willing to experience volatility of your principal, and understand it is not an FDIC insured savings account that has guarantees.
Have you heard that companies are reporting record profits and cash on their balance sheets?
Paying out a higher dividend to shareholders is a viable option for a company to make use of that cash. Currently, we are seeing signs that companies are starting to do exactly this — paying a higher ‘rent’ to their shareholders.
Investing in stocks that pay dividends is not without risk.
It is important to have a general understanding of a few key issues. Obviously, a best case scenario is that you own a stock that appreciates greatly while being paid a quarterly dividend all along. Realistically you may seek dividend paying stocks for the hope of some appreciation or return of your original investment with a predictable dividend income paid to you while you hold the investment. However, it is vital that you are aware that the worst case scenario is that your principal investment declines significantly and the company announces it can no longer pay a dividend — that would be the equivalent of a landlord losing their tenants while seeing their property value significantly depreciate.
What factors should I consider when evaluating dividend paying stocks?
Dividend Payout Ratio: the ratio of dividends to earnings. Dividends are generally paid out of earnings. The company may pay some of these earnings to you as the shareholder and retain some to put back into the company.
- More mature companies tend to have higher dividend payout ratios.
- Lower dividend payout ratios that are increasing are a sign of a company’s strength and the management’s belief that they can continue to make these payments. Otherwise, they would not increase the dividends.
- Certain industries have historically paid higher dividends (e.g. utility companies).
- Conversely, companies that cut their dividend ratio are historically indicating weakness and you want to approach these companies with extreme caution.
- Exceedingly high dividend payout ratios may be too good to be true so approach these with caution as well.
Dividend Yield: the yield which represents the income from dividends divided by the share price.
- This is the annual income the company is indicating they will pay based on the most recent dividend paid.
- The yield will go up when the stock price goes down.
- The yield will go down when the stock price goes up.
- The yield can go up or down if the company changes the amount they pay out.
- Under current law, dividend paying stocks that are considered qualified are taxed at 15 percent as opposed to a more common income tax rate such as 25 percent or 28 percent.
- For those in the 0 percent to 15 percent income tax bracket, the tax rate on ‘qualified dividends’ is 0 percent!
- If you sell the stock, mutual fund or ETF at a profit, you may owe capital gains tax as well.
- If you sell the stock, mutual fund or ETF at a loss, you may be eligible for a capital gains loss.
- The current tax law could change so pay attention to the legislative environment.
Dividend Reinvest or Cash
- Keep in mind you can use your dividend income to buy more shares of your investment or you can have your custodian or broker pay the dividends in cash to you.
Stock market volatility can be disheartening to anyone. Evaluate ways to cushion the roller coaster ride of stock price fluctuation with a steady stream of dividend income. Just as a landlord seeks to receive a positive cash flow from rent, an income and growth investor can seek dividend paying stocks for positive cash flows. Most diversified portfolios have a portion invested in equities. If you allocate some of your portfolio towards equities, then consider dividend paying stocks as a core position within the equity portion of your portfolio.
1 Standards & Poors, Ibbotson, J.P. Morgan Asset Management
FPA member Scott Hughes, CFP®, MBA, is a Financial Planning Advisor and President of Hughes Financial Services, LLC, in Herndon, VA. Hughes Financial Services, LLC, is a branch office of and Securities offered through WFG Investments, Inc. (WFG). Member FINRA/SIPC. Scott Hughes is a Registered Representative of WFG.