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Meat and Potatoes Portfolio: Aim for Income from Dividends?

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October 22, 2015
Meat and Potatoes Portfolio: Aim for Income from Dividends?

Dividend investing can be a relatively straightforward system of stock trading and many investors fancy this approach for its income-producing means. It’s also been a go-to approach in the search for higher yields in a current low-interest-rate environment or during unforeseen market swings. That’s because some investors believe a dividend-inclusive strategy offers potential for appreciation and diversification that can offset some volatility.          

“With stock prices decreasing and if dividends are staying constant, the dividend yield is higher and can represent an opportunity to potentially continue a prior income stream during a downturn,” says Matt Sadowsky, director of retirement and annuities for TD Ameritrade.

But, he warns, like any stock investment: “Dividends are not guaranteed.”

Indeed, they’re not. When the economy tanked and the stock market collapsed in 2008 and 2009, companies pulled the reins in on their dividend payouts, with many cutting them substantially. Earnings volatility can change payout ratios considerably, too, meaning that companies could end up disbursing a much bigger piece of their profits when earnings have declined if dividends aren’t adjusted.

But some investors are big fans of dividend investing because dividend patterns can, they say, disclose much about the health of a company. 

Time-Tested?

One approach is to invest in companies with long dividend track records. If they’ve been around for decades, those who follow this thinking say they know something’s working and it’s working well enough that the excess cash has been distributed in the form of dividends. The counter point appears when some investors ask why the dividend is being sent to them, instead of those earnings being "plowed back" into the business. Companies that can withstand the test of time do it by reinventing themselves and adjusting to the changing landscape of their industry and the customers.

Dividend-payers can be companies in fast-changing sectors such as technology, although this is rare, or in slower-growth sectors such as banking. The consumer-products sector is another example. Consumer tastes and needs are in a constant state of flux. If a company can weather that over generations, and pay dividends along the way, the dividend fans say it potentially shows staying power.

Remember, too, that yield—what you might think of as income—are calculated as a percentage of the share price and are inverse to those prices. It’s why investors tend to flock to dividend-yielding companies when markets are volatile. If the annual dividend per share is $1.33 and the share price is $86, the yield is 1.54%. If the share price drops, say, to $79, the yield goes up – in this case to 1.68%. Calculating the yield is simple math: DPS / SP X 100 = Yield.

Of the S&P 500 stocks, 400 of them pay dividends, according to Standard & Poor’s data; the majority pay between 1% and 2% yields. The average of all 400 stocks is 2.2%, well ahead of most money-market and savings accounts payouts in the current interest rate environment. Fewer than 40 will pay out 4% or more, but there’s a hefty amount of companies that lie in between 2% and 4%. 

Don’t Be a Chump

Beware of what the industry refers to as the “sucker yield” or the “value trap,” which is when a company proffers a too-good-to-be-true dividend yield. It’s highly likely that the dividend lure is hiding something far more valued: flawed fundamentals or management. They tend to be most prevalent in companies that have roller coaster earnings histories.

“If a stock seems to pay a dividend yield that is exceptionally high, investors should look harder at the sources of payment behind the dividend,” says Brad Thomas, a Seeking Alpha contributor and editor of the Forbes Real Estate Investor newsletter. “That is, how profitable is the company? Can the sources of income cover the dividend payment? How sustainable is the dividend? Are there threats to the underlying business model?”

“When a company is paying a dividend beyond its earning power it is essentially eroding capital,” he adds.

And you have to wonder why one company is willing to pay out so much more than its peers.

Research Payout Ratio

Another meaningful gauge to weigh is the dividend payout ratio, which is the portion of the company’s income that is disbursed in dividends and a key measure of a company’s profitability, sustainability and even maturity. Younger companies, for example, are likely to keep most of their profits to reinvest in growth while a more mature company will give back a healthy dividend over a long period of time. Typical dividend investors tend to want to look for a steady stream of dividends that rise in a consistent manner year to year, which they feel underscores the sustainability.

If the ratio is high, it could be a sign that the company is returning much of its profit to shareholders. Sometimes, that’s great; other times, it reflects a not-too-worrisome blip in earnings, say during a deep recession; and still there are times when it signals trouble. The biggest red flag is when the company is paying out more than it’s making (remember that the yield rises and falls with the share price while the ratio gives investors an idea of how much the company is reinvesting in its operations).

The easiest way to figure out the ratio is to divide annual dividends per share by annual earnings per share, both of which can be found on a firm’s income statement or consolidated statement of operations. If the dividend per share is $1.83, and earnings per share is $6.45, the ratio will be 0.28. DPS / EPS X 100 = DPR, or 28%.

Bottom line: a little history, some math, and dividend-focused investing could be one way to pursue income and still partake in the stock market’s potential.

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