The Little Book of Big Dividends

1. Dividends Matter: Nearly Half of Stock Market Returns Come from Dividends

Roughly 40 percent of the stock market's long-run total return comes from dividends.

Dividends provide stability. In times of market volatility, dividends offer a cushion against price declines. They represent a tangible return on investment, independent of market sentiment. Companies that consistently pay dividends tend to be more stable and financially sound.

Dividends contribute significantly to total returns. Over long periods, reinvested dividends can account for a substantial portion of an investor's wealth accumulation. For example, a $5,000 investment in Exxon in 1982 would be worth $346,000 today, largely due to reinvested dividends.

Dividend-paying stocks offer dual benefits:

• Regular income stream
• Potential for capital appreciation

2. Yield is a Proxy for Risk: Be Cautious of Unusually High Yields

Dividend yield is a pretty good proxy for investment risk.

High yields can be deceptive. An unusually high yield often signals that the market expects a dividend cut or other financial troubles. For example, Thornburg Mortgage's 20% yield in 2007 preceded its bankruptcy in 2009.

Red flags for dividend investors:

• Yield significantly higher than sector average (3+ percentage points)
• Yield 4-5 times higher than overall market average
• Yield much higher than company's historical average

Focus on total return. Instead of chasing the highest yields, investors should consider a stock's potential for both dividend growth and capital appreciation. A lower-yielding stock with strong growth prospects may provide better long-term returns than a high-yielder with limited growth potential.

3. The Basic BSD Formula: Focus on Payout Ratio and Overall Investment Merit

Pick dividend-paying stocks on their merits, not your needs.

Payout ratio is crucial. This metric, which measures the percentage of earnings paid out as dividends, is a key indicator of dividend sustainability. A payout ratio below 60% generally indicates room for dividend growth, while higher ratios may signal potential cuts.

Consider overall investment quality. The author's Basic BSD Formula combines payout ratio with an overall quality score (like Quadrix) to identify attractive dividend stocks. This approach helps investors avoid the "dividend trap" of picking stocks solely based on yield.

BSD Formula benefits:

• Outperformed S&P 1500 by 4+ percentage points annually since 1994
• Lower risk than the index (as measured by standard deviation)
• Better at avoiding dividend cuts (only 5% of stocks cut dividends in 2008)

4. Global Dividend Opportunities: Expand Your Investment Horizon

When you're hunting for attractive dividend-paying stocks, keep in mind that more than two out of every three dollars invested in stocks globally is invested in companies outside the United States.

ADRs provide easy access. American Depositary Receipts (ADRs) allow U.S. investors to easily buy shares of foreign companies. Many quality foreign stocks pay attractive dividends and offer geographic diversification.

Consider emerging markets. BRIC countries (Brazil, Russia, India, China) offer strong growth potential and increasingly stable dividend streams. However, these markets can be volatile, as evidenced by significant declines in 2008.

Benefits of international dividend investing:

• Expanded opportunity set
• Potential for higher yields in some markets
• Currency diversification
• Exposure to faster-growing economies

5. Direct Purchase Plans: Cost-Effective Way to Buy Quality Dividend Stocks

With direct-purchase plans, any investor has an easy and affordable way to buy quality dividend stocks.

Low-cost entry point. Many direct purchase plans allow initial investments of $250 or less, making it easy for small investors to start building a dividend portfolio. Some plans even offer fractional share purchases.

Avoid commission drag. By eliminating brokerage fees, direct purchase plans allow more of your money to work for you. This is especially beneficial for investors who make regular, small investments.

Additional benefits:

• Automatic dividend reinvestment (often at no cost)
• Dollar-cost averaging through regular investments
• Some plans offer discounts on share purchases
• IRA options available with some plans

6. Dividend Growth: A Powerful Hedge Against Inflation

Buying dividend growers is not just a good idea as an inflation hedge; it's a good idea because dividend growers, as a group, outperform the market.

Inflation protection. Companies that consistently increase their dividends help investors maintain purchasing power over time. A 3% annual dividend increase can offset a similar rate of inflation.

Accelerated payback. Dividend growth reduces the time it takes to recoup your initial investment through dividends alone. This "payback period" concept provides a useful framework for comparing dividend stocks.

Characteristics of strong dividend growers:

• Low payout ratios (room for dividend increases)
• Consistent profit and cash flow growth
• History of annual dividend increases
• Strong competitive positions in their industries

7. Reinvest Dividends: Compound Your Way to Wealth

If you want to build wealth over time, cashing your dividends is not the way to go. Reinvesting them is.

Power of compounding. Reinvesting dividends allows you to purchase additional shares, which in turn generate more dividends. This snowball effect can dramatically accelerate wealth accumulation over long periods.

Emotional benefits. Dividend reinvestment plans (DRIPs) provide a form of forced savings, helping investors buy more shares during market downturns when they might otherwise be hesitant to invest.

DRIP advantages:

• Often commission-free purchases
• Fractional share ownership
• Some plans offer discounts on share purchases
• Automatic, disciplined investing

8. Diversify with Caution: Use Exotic Dividend Investments Sparingly

If you have more than 20 percent of a portfolio in the types of risky dividend stocks discussed in this chapter, that's too much.

High-yield options carry risks. Investments like REITs, MLPs, and royalty trusts can offer attractive yields but come with unique risks and tax implications. They should be used in moderation within a diversified portfolio.

Consider alternatives carefully. Preferred stocks, annuities, and high-yield bonds can provide income but may lack the growth potential and inflation protection of dividend-growing common stocks.

Risky dividend investments to use sparingly:

• Real Estate Investment Trusts (REITs)
• Master Limited Partnerships (MLPs)
• Royalty Trusts
• High-yield bonds
• Preferred stocks

9. Create Your Own Dividend Portfolio: Balance Yield, Growth, and Safety

Long-term investment success depends on the whole—your portfolio.

Diversification remains crucial. While 2008 showed that correlations can increase during crises, proper diversification across asset classes and sectors still helps manage risk over the long term.

Balance current income and growth. Construct a portfolio that provides a mix of high-yield stocks for current income and dividend growers for long-term appreciation and inflation protection.

Portfolio construction considerations:

• Mix of U.S. and international stocks
• Blend of high-yield and dividend growth stocks
• Use of low-cost direct purchase plans where available
• Careful integration of higher-risk, high-yield investments
• Regular rebalancing to maintain desired allocations

Last updated: November 19, 2024