Get Rich with Dividends

1. Dividend-paying stocks outperform the market over time

Companies that raised or initiated dividends from 1972 to 2010 did significantly better than those that didn't.

Historical outperformance. Dividend-paying stocks have consistently outperformed non-dividend payers over long periods. From 1972 to 2010, dividend raisers and initiators generated a compound annual growth rate of 9.84%, compared to 7.59% for dividend maintainers and 1.76% for non-payers.

Stability and quality. Companies that pay and raise dividends tend to be more stable, profitable, and well-managed. They often have strong cash flows, established business models, and a commitment to returning value to shareholders. This stability can lead to lower volatility and better risk-adjusted returns over time.

Dividend Aristocrats. The S&P Dividend Aristocrats Index, which includes companies that have increased dividends for at least 25 consecutive years, has significantly outperformed the broader S&P 500 index. From 1990 to 2011, Aristocrats returned 901% versus 469% for the S&P 500.

2. The power of compound interest: Reinvesting dividends accelerates wealth

Compounding is all about momentum. The first several years, it seems like not much is going on, but watch what happens once you get a few more years out.

Exponential growth. Reinvesting dividends allows investors to purchase additional shares, which in turn generate more dividends. This creates a powerful snowball effect that accelerates wealth accumulation over time. The impact of compounding becomes more pronounced the longer an investor stays invested.

Real-world example. A $10,000 investment in Procter & Gamble in 1981, with dividends reinvested, would have grown to $582,725 by 2011. This same investment would generate $18,341 per year in dividends alone, nearly double the original investment amount.

Patient investing rewarded. While the effects of compounding may seem small in the early years, the power of reinvested dividends becomes increasingly significant over longer time horizons. Investors who can resist the urge for immediate income and instead reinvest dividends can potentially achieve much higher total returns.

3. Seek companies with a history of consistent dividend growth

Chances are, a company that has raised its dividend for 25 years in a row is going to do it again in year 26. And again in year 27. And in year 28.

Dividend growth indicators:

• Dividend Aristocrats: S&P 500 companies with 25+ years of consecutive dividend increases
• Dividend Champions: Any company with 25+ years of consecutive dividend increases
• Dividend Contenders: Companies with 10-24 years of consecutive increases
• Dividend Challengers: Companies with 5-9 years of consecutive increases

Management commitment. Companies with long dividend growth streaks demonstrate a strong commitment to shareholder returns. This often reflects confident management teams and stable, growing businesses.

Inflation protection. Dividend growth helps protect investors from the eroding effects of inflation. A company that consistently raises its dividend at a rate higher than inflation helps maintain and increase the purchasing power of the income stream over time.

4. Focus on dividend safety: Payout ratio and cash flow are key

Cash flow is a bit harder to fudge. Of course, a motivated executive who wants to commit outright fraud probably can do so, but manipulating cash flow numbers is more difficult as it represents the actual amount of cash generated by the company.

Payout ratio. The payout ratio (dividends paid divided by earnings or cash flow) is a crucial metric for assessing dividend safety. A lower payout ratio indicates more room for dividend growth and a better ability to maintain dividends during downturns. Aim for payout ratios of 75% or lower for most industries.

Cash flow focus. When evaluating dividend safety, prioritize cash flow over reported earnings. Cash flow is harder to manipulate and provides a clearer picture of a company's ability to sustain and grow dividends. Look for companies with consistent and growing free cash flow.

Warning signs:

• Sudden spikes in payout ratio
• Declining cash flow or earnings
• Stagnant or decreasing dividend growth rates

5. The 10-11-12 System: A framework for dividend investing success

To achieve 11% yields and 12% average annual returns in ten years, we'll need to make some assumptions.

The system explained:

• 10: Aim for a 10-year investment horizon
• 11: Target an 11% yield on cost after 10 years
• 12: Seek a 12% average annual total return over 10 years

Key components:

1. Starting yield: Aim for 4.7% or higher
2. Dividend growth rate: Look for 10% annual growth or higher
3. Payout ratio: Seek 75% or lower (based on cash flow)

Flexibility and adaptability. While these targets provide a solid framework, investors should remain flexible. Market conditions and individual stock characteristics may require adjustments to achieve the best risk-adjusted returns.

6. Diversification is crucial, even within dividend stocks

Although it may be tempting to load up on dividend payers with 10% yields, that's likely a recipe for disaster.

Sector diversification. Spread investments across various sectors to reduce risk and capture different economic cycles. Consider exposure to industrials, technology, energy, healthcare, consumer staples, and other sectors.

Yield range. Don't focus solely on the highest-yielding stocks. A mix of yields can provide both current income and future growth potential. Balance higher-yielding stocks with those that have lower yields but higher dividend growth rates.

Company size and maturity. Include a mix of large, established dividend payers (like Dividend Aristocrats) along with smaller companies or those earlier in their dividend growth journey. This can provide stability and the potential for higher future growth.

7. Use options strategically to enhance dividend stock returns

Selling a covered call is a great way to boost the income you receive from your stock holdings.

Covered calls. Selling covered calls against dividend stocks can generate additional income, potentially boosting overall returns. This strategy works well for investors seeking current income rather than long-term capital appreciation.

Benefits:

• Additional income beyond dividends
• Potential downside protection
• Opportunity to sell stocks at higher prices

Risks:

• Limiting upside potential if stocks rise significantly
• Potential for stocks to be called away
• Requires more active management

Put selling. Selling cash-secured puts can be a way to potentially acquire dividend stocks at lower prices while generating income. This strategy is more complex and carries additional risks compared to covered calls.

8. Consider international dividend stocks, but be aware of unique risks

Many foreign dividend payers currently have considerably higher yields than their American counterparts.

Potential benefits:

• Higher yields
• Geographical diversification
• Exposure to different economic cycles and growth opportunities

Unique risks:

• Currency fluctuations affecting dividend payments
• Political and economic instability in some markets
• Less frequent dividend payments (often semi-annual or annual)
• Potential for lower accounting and regulatory standards

Approach. Treat international dividend stocks as a complement to a core portfolio of domestic dividend growers. Limit exposure to manage risk while still capturing potential benefits.

9. Tax implications: Understand the benefits of qualified dividends

Dividend tax rate=15%

Qualified dividends. Most dividends from U.S. companies and many foreign companies qualify for preferential tax treatment. As of 2012, qualified dividends are taxed at a maximum rate of 15% for most investors, compared to ordinary income tax rates.

Tax-advantaged accounts. Consider holding dividend stocks in tax-advantaged accounts like IRAs to defer or potentially eliminate dividend taxes. This can significantly enhance long-term returns through more efficient compounding.

Special cases:

• REITs, MLPs, and BDCs often have unique tax implications
• Some distributions may be classified as return of capital, affecting cost basis
• Foreign dividend taxes may be eligible for a tax credit

Stay informed. Tax laws can change, potentially affecting the after-tax returns of dividend investing strategies. Consult with a tax professional and stay updated on relevant tax policies.

Last updated: September 12, 2024