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Why Dividends Stocks Rock

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If you can keep your wits about you while all others are losing theirs, and blaming you. . . . The world will be yours and everything in it, what’s more, you’ll be a man, my son.

That’s a famous line from Rudyard Kipling’s If and if you followed that advice the last year (the first part anyway), especially in the stock market, you would’ve done very well and kept a few gray hairs at bay. Since the S&P hit its low in March of 676.53, it’s come roaring back a stunning 63.4% since then. While it’s still down from where it was before the recession (it was 1251 on Sept 19, 2008, down 11.64%), you have to admit it’s a pretty amazing recovery in such a short period of time.

We benefited from being young, with decades until retirement, and one thing we’ve been looking into is dividend yielding stocks in our regular non-retirement brokerage accounts.

Favorable Tax Benefits

Dividends are taxed at the investor’s long term capital gains tax rate, which is 0% for taxpayers in the 10% and 15% tax brackets and 15% for everyone in the 25%, 28%, 33%, and 35% tax brackets (see 2009 tax brackets).

It’s a common strategy for those on fixed income to invest in dividend yielding investments for this very reason. Interest from your savings account is taxed as ordinary income, making the tax equivalent yield (tax equivalent yield calculator) of a dividend bearing stock at the same percentage much higher.

This makes them well suited for non-retirement accounts, where taxes are a constant factor in decision making. In a Roth IRA, it wouldn’t matter because nothing is taxed. In a Traditional IRA, everything is eventually taxed at your marginal tax rate. Being in this middle ground gives you no benefit.

Why Dividends Suck

The biggest argument against dividends is that a company should retain those earnings to grow the business and subsequently it’s share price. If a company is writing checks to its shareholders, paying for it with earnings, then those dollars can’t be used for capital investments, new hires, new projects, etc. It’s not difficult to see the logic in that argument.

To this I have two counter arguments:

  • Most companies that offer dividends aren’t in super-charged growth mode and the earnings they don’t pay, on an absolute level, are sufficient to grow the business. For example, Merck pays a 4.05% dividend right now and they just bought Schering-Plough for $41.1 billion in cash and stock. They paid a healthy dividend and were able to build their business.
  • The dividend stocks I’m looking at are all going to be stable blue chip companies with good dividend coverage. That is to say the stock price isn’t going to gyrate too much and their cash flow from operations can cover their dividends by a healthy margin. I’m not looking for growth, I’m looking for stability.

Finding Dividend Yielding Stocks

As I mentioned before, it comes down to dependability and coverage. The best place to start is with companies that have paid out a dividend for years and this Fool.com list isn’t a shabby place to start. I don’t own any stocks on their “dividend dynamite” list but I think I might in the near future.

Another way is to simply buy a dividend fund. Vanguard has their Dividend Growth Fund (VDIGX), with an expense ratio of 0.32%, a yield of 2.08%, and holdings in 49 different stocks. Fidelity’s version (FDGFX) has an expense ratio of 0.62%, a yield of 1.90%, in 483 companies. A dividend fund gives you a little protection with diversification at the cost of an expense ratio.

Do you do any dividend investing? Do you have any tips and tricks for a novice like myself? Do you absolutely hate the idea of dividends?

{ 26 comments, please add your thoughts now! }

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26 Responses to “Why Dividends Stocks Rock”

  1. Julio says:

    Great Quote, but who was the author?

  2. Foo Finance says:

    I personally like dividends. I am of the opinion that if the company does not have opportunities to reinvest the money at a profitable rate they should pay out in dividends. Having the cash flow allows you to reduce your risk a little since you get some of your investment back.

    The tax treatment is a bonus and you can also reinvest the dividends if you want. I do exactly that with a couple stocks myself and it allows for a little bit of dollar cost averaging, without commissions, and my dividends grow with my increase in the holding. The idea is to stop the reinvestment at retirement and use the dividends for expenses since they are already in a taxable account.

    Just be sure to do your homework before buying dividend stocks. Make sure you would be ok holding them for the long term and look at the dividend track record. I tend to go for those with a relatively steady increase in dividends and profit as a sign of stability.

    Hope this helps!

    - Foo

    • saladdin says:

      I don’t understand. A company should pay dividends or invest the money but not use it as retained earnings to grow the company?

      saladdin

  3. Jay says:

    Check out http://www.dividendgrowthinvestor.com/. A great blog for analysis of dividend stocks.

  4. HT says:

    Dividends are great. Dividend paying funds are good. PEY is my personal favorite. Don’t believe the Google finance page they still pay their dividend. They pay a monthly dividend that works out to a hair over 6% at current price (based on their last monthly payment annualized).

    -HT

  5. Stephen says:

    I was going to ask you to write about dividend paying stocks. You read my mind :)

  6. redivelli says:

    You have to remember to keep the Dividend Yield in perspective. I own several dividend stocks and right now they are doing pretty well (2 REITS and 2 services). For the stocks with higher yields people like to jump in around the ex -div date and the price jumps up a lot; those folks are just wanting the money and will soon back out.

    Be wary if a div yield is too high, it could be a bad indicator.

    I am happily sitting on a combined ~7% yield in div’s :)

    • redivelli says:

      **It’s a good idea to look at how long dividends have been paying out at the Fool site. I like to look at who steadily increases their div too. Note the link at the bottom of that fool article.

    • Jim says:

      People who jump in around ex-div date are screwing themselves, because the price of the stock immediately falls by the div amount. You essentially take an immediate tax hit, which is why people advise against buying mutual funds near the end of the year (because that’s when they settle up on dividends and their taxes).

      • saladdin says:

        That’s what I don’t get about the love for dividend stocks. If the stock price decreases because of paying the dividend then isn’t it in theory a wash? Why so much love for a dividend then?

        saladdin

    • MoneyReasons says:

      I’m with you on this one, I just started dabbling with REITs, but so far then are doing very well for me. You just have to remember that you bought the REIT for the dividend yield, not growth.

      I also invest in some energy stocks, like BP, KMP, LINE… Boy I wish I bought some LINE when the dividend was around 18%. Now it’s down to 10% :(

      The REITs are trusts, so the tax treatment is a little different than regular stock. I think it would be wise to research how the taxes are handled before you jump into REITS.

  7. If the dividends are received as cash it’s always nice.

    John DeFlumeri Jr

  8. I also like stocks that not only have a dividend, but also their dividend increases yearly. My fav, XOM. It has increased yearly for the past 20+ years. So your yearly net dividend increases over time!

    Also it should be noted that the IRS taxes dividends currently at 15%, but this is a tax-relief provision could expire after 2011 if not renewed. With deficits at the rate they are going don’t expect them to stay at this rate.

  9. pmulroy says:

    Saladdin,

    Stock prices do not “decrease because of paying the dividend”. You don’t simply count up all the assets of a company, subtract the liabilities and then divide by the number of outstanding shares to get the stock price.

    Perhaps you are confusing what happens with a mutual fund paying out dividends. With mutual funds, the net asset value is calculated at the end of each day. When dividends are distributed, the net asset value per share will of course drop by the amount of dividends per share distributed and therefore the price of each mutual fund share will drop.

    While it may seem intuitive that stocks should work the same way, they don’t. There is a lot more that goes into pricing a stock. To see proof of this, think of what would happen if a company announced it was no longer going to pay a dividend just before the ex-dividend date completely unexpectedly. With your reasoning, the stock price wouldn’t decrease because they are saving the dividend payout. In reality, the stock would tank after such an announcement out of the blue.

  10. Guy in SA says:

    I love dividend stocks. I like Frost Bank, a very conservative Texas Bank who turns down a lot of deals, pays around a 4% dividend. Also, the EFT fund PFF is a preferred stock dividend fund, check that one out. It pays monthly. Another one that pays above 3% would be Kraft Foods (KFT).

    The key I believe is to invest in a company that can continue to pay (not too high, not too low).

  11. Arohan says:

    The one benefit I see of dividend stocks is a confirmation that the company in question is really enjoying a positive cash flow and is not making up their accounting profits. This is a valid concern for many investors.

    On the other hand, it is quite inefficient income tax wise to earn a dividend as the company pays dividends using their AFTER tax money and the investor ends up paying tax on the dividends again. It makes more sense for the company to retain their earnings and reinvest in the business if it can generate a good return on invested capital. (if the company does not have projects with good ROIC to invest in and is therefore making dividend payments, than the company is not a good investment in the first place)

    Yes, many great and strong companies pay dividends. I just think it is not wise use of the shareholder wealth to continually carve out 15% or so in unnecessary taxes to Uncle Sam every year

  12. Good post. One thing that is especially beneficial about dividend stocks is dividend growth. There are many companies out there that have made it a habit to increase their dividends year after year.

    What this means to the investor is that for every year they own the stock, their dividend income from that stock continues to rise. If you funnel these increasing dividends into more and more shares of the same company (or other investments for that matter) then you achieve a compounding effect. It can really add up over time.

  13. I agree with most of the comments. I do own some dividend paying stocks for that purpose.

    Unfortunately I bought several good dividend paying bank stocks as they were going down several years ago because the returns based on price was so good. Of course they subsequently stopped paying. I am hoping as they recover they will start back up and since I got in low I can one day have a good ROI.

    Personally now I would stick with oil stocks or something in the health category.

  14. A professor I had in college (for an investment course) emphasized that there is a difference between investing and speculating, and that what most people call investing is actually speculating.

    Investing is buying a cash flow, as in dividend paying stocks. Speculating is buying for price appreciation, and often ignores cash flow all together.

    I think that’s a crucial issue in investing. A company paying dividends is rewarding it’s stockholders for the use or their money, and plans to be around a while. The key it seems is to look for stocks that have been paying dividends reliably for several years.

    Several investment types have recommended that the bulk of your money should always be in income producing assets, but I think we’ve mostly lost that since the 1980s.

    My guess is that it’ll be more important in the future.

    • Chris says:

      Well put…dividend distribution plans are created by the board of directors and are generally long term plans. Most true investors like to see reliable non-fluctuating dividends as compensation for their risk investing in that firm.

  15. otipoby says:

    something I learned from my graduate class in financial valuations that is not necessarily intuitive

    The current stock price of an equity is equal to the market’s expected present value of all future dividends, discounted at the appropriate cost of equity for the firm.

    Actually, this is true of ANY asset (PV of expected free cash flow, discounted appropriately).

    • Jim says:

      Yeah, that’s known as the Dividend Discount Model. It’s intuitive if everyone in the market played by the same playbook, knew how to value companies with the “how” being identical. However, everyone doesn’t and so the current price of a stock includes that and other factors that are hard to quantify.

  16. Sandra says:

    Thanks for the valuable articles here!
    Having read this and other articles about investing, I’ve decided that (in addition to other investments) a dividend fund is good for me. I have two Vanguard funds that I’m watching: VWEHX and VFICX. Here’s my question: Is mid-December a good time to put $ in? Or would it be better to wait until January? (And how would I know?)
    Thanks!

  17. LS Mong says:

    Jim…I enjoyed your comments and candid youthful rationale. I’m a few years older (leave it at that). As a retired public accountant of 35 yrs+/from my brief approx. 1-1/2 yrs very intense research / due diligence starting at the beginning of 2010 plus subscribing to “High-Yield Investing” and “Dividend Detective” and tried a few others and cancelled and enjoyed reading dividend books like…Dividend Capture, The Power Curve, The Dividend Growth Investment Strategy, and currently reading All About Dividend Investing (my favorite), I’ve concluded with continue fine tuning that Monthly Dividend stocks with the Mo.DRIPs generate the most consistent compounding and rewards / satisfaction. I’ve set up over a dozen pre-screening portfolio on Yahoo Finance to sort thru the boat load of data. I look at some core fundamentals like yield, Ex-Date, 52 week trading range, 200 day mov. ave, 50 day mov. ave. and only make entry (buys)on dips.
    My only (20/20 Hindsight)regret is that I hadn’t started at your young age. Be Safe!


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