Stocks are normally considered the growth asset par excellence, held by investors looking for long term, potentially volatile gains. Over the long run this is indeed correct; the average return of equity investors is unrivalled by other asset classes, a particularly enviable characteristic during periods of rising inflation. But stocks can also be used for income generation, in a similar way to bonds, by investing in certain sectors known as dividend-paying stocks. These stocks are normally those of stable, income-yielding industries, companies that aren’t trying to radically reinvent their industry but instead have a profitable, and jealously protected, niche to exploit. Utility companies, tobacco companies, and consumer goods companies are the most reliable dividend payers. Large mining companies, known as ‘majors’ are also known to pay dividends, as are some oil and gas companies, but this sector also includes exploratory and high-risk, high-growth business models so is not a ‘classic’ dividend paying sector. Individual companies in other sectors, such as pharmaceuticals, have also paid out dividends very reliably, in some cases for over a century.
Why pay dividends?
The expense of a large dividend payment can be phenomenal – choosing to regularly pay one is a major signal to investors about the profitability and credit-worthiness of the business. This is then rewarded with continued inward investment into the stock, with dividends often reinvested as a matter of course. Particularly for companies that do not need the cash for new acquisitions or expansion, or who can fund those activities by other means such as cheap debt, paying a dividend is a way of rewarding and attracting investors.
Dividends can become a trap however – some stocks are known as reliable payers, and sometimes the business suffers in order to gather enough cash to make the payment. Income investors always look closely at whether a dividend payment is affordable – signs that a company is bleeding itself dry to make dividend payments will not be well received by most investors.
Are dividends guaranteed?
Absolutely not! One of the main issues with dividend income portfolios is that companies can – and do – turn around and cancel a dividend with no warning or justification. This will normally harm the share price, and consistency is expected from a healthy, well-run company, but should they run into trouble the first thing they cut or scrap will be their dividend. Some sectors, especially tech, have a policy of never paying dividends, something which investors overlooked or even encouraged during the 20 year bull run from 2001 – 2021.
Reliable dividend payers are important for income investors, as their portfolio return will depend on the percentage dividend yield. If a stock regularly pays out a dividend of 5 cents on the dollar, this allows for a yield of 5% to the overall portfolio (assuming it was all in this stock), a very healthy return and one that will often also see significant capital gains – unlike an equivalent bond portfolio.
How are dividends paid?
Dividend payments will depend on the method you use to access the stock. If you are using a dividend stock ETF, mutual fund or other collaborative investment vehicle, you will need to decide whether you want a fund that pays out the income as a coupon, or automatically reinvests them. For investors seeking income, the former option is obviously preferable, but capital gains will be significantly higher in the latter case.
You need to make sure your portfolio is sufficiently well funded to support the income you require. If you are able to secure a dividend yield of 3%, and you require an income of $30,000 per year from the portfolio, you will need $1,000,000 in the portfolio. Unlike a bond portfolio, you will continue to see capital gains on that $1,000,000, but you must also remember that stock prices can fall as well as rise, and that dividend-paying stocks are usually, but not always, less ‘star performers’ for growth than high-growth, low-dividend stocks. The latter point is of course dependent on overall market conditions; in certain environments dividend-paying stocks may return well from both a capital gains and income perspective.
Selecting a dividend portfolio
Because stocks, even those of major companies with a stable dividend history, are inherently volatile assets, you do not want a concentration risk in just a few companies – instead spread out across sectors, to avoid a correlated decline in asset value. Unlike with a bond portfolio, where credit worthiness can be indicated by its rating, you will need to actually look at the financials of any stocks before you buy them. Remember to check for stable revenue, a stable cost base and continuity among senior management. It is also worth looking at metrics more normally considered by value investors such as the P/E ratio – but remember a reliable dividend payer will always be slightly more expensive than its peers.
If you have a large enough total portfolio, say $1,000,000 aiming for $30,000 in stable income, split your holdings so no one company holds more than 5% allocation, and no sector more than 20%. This means you can hold 20 stocks across the energy, major mining, consumer goods, tobacco and retail sectors, as well as potentially certain financial companies such as mortgage providers (this sector less popular post-2008), which is relatively concentrated in terms of number of individual stocks, but given the broad base of different industries avoids an over correlation.
Dividend paying stocks are never fashionable, but they are consistent outperformers, both from a growth perspective (if you reinvest the proceeds), and of course for income-seekers they are the only real alternative to bonds, barring complex, bureaucratically challenging projects like buy-to-let. Investors need to be aware of the extra volatility compared with bonds, and the risk of both dividend cancellation and company failure in extreme cases. By carefully screening potential stocks, and considering the correlations between the holdings in your portfolio, diversifying according to geography and sector, investors can minimise the risks of equity volatility while preserving a health income potential.