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Guide to Dividend Stock Investing

This is a short course about investing in dividend stocks. We go over the risks and rewards involved as well as the red flags to watch out for.

Prerequisites

You should already be familiar with the basics of dividend investing such as the meanings of a dividend, dividend yield, etc.

What makes a Good Dividend Stock?

Theoretically speaking, investors want two simple things from a dividend stock:
  1. 1- A high dividend
  2. 2- The ability to keep paying that high dividend

Although these seem simple, in practice it is quite difficult to find stocks that satisfy both 1 and 2 in the above. There's also an inverse relationship between these two requirements, namely stocks that pay a very high dividend typically cannot keep paying it for a long time.

We discuss each requirement separately:

High Dividend Yield

Finding stocks with high dividend yields is easy. In fact, Hedge Follow offers a periodically updated list of high dividend stocks for information purposes. The main difficulty is knowing which stocks that can sustain that high dividend.

Unfortunately investors often overlook sustainability and place too much emphasis on the stock having a high dividend yield. Unrealistic expectations for the dividend leads them to favor stocks with higher yields, often overlooking with modest yields but much better sustainability. Instead, an investor should look for reasonably good yields along with good sustainability.

What is a Reasonable Yield?

Most "Dividend Stocks" tend to have yields between 1% and 5%. Anything much higher than that should raise suspicion about the prospects of the stock continuing to make the dividend payments.

Sustainability of the Dividend

Now comes the difficult part, how can an investor be confident that the stock will be able to keep paying the dividend? Historically there have been two factors that made it easier for companies to maintain their dividend.

The first is operating in an industry with very high barriers to entry. This kept a company's business relatively stable, allowing it to make good on its dividend payments. Unfortunately in today's competitive world it is not easy to find such stocks. Due to the relative ease of raising capital, even giant companies are facing competition from new startups. Nonetheless, one can still find stocks with competitive advantages that place them above their competition.

The second is the size of the company. Larger companies can make it very difficult for newer companies to compete. They can take larger losses and survive economic downturns more easily. A larger company is therefore more likely to sustain its dividend payment.

Neither of the factors above can guarantee future payments, and ultimately it comes down to the investor's discretion and fundamental analysis of the company. Generally speaking, a dividend investor desires a company that is generating healthy cashflows from its operations; cash flows that are enough to make dividend payments as well as fund business operations and new investments. Analysis and forecasts of future cash flows (and risks to those cash flows) can shed light on the ability of the firm to make dividend payments in the future.

Disadvantages of Dividend Investing

The advantages of dividend investing and income investing in general are well known. Typically you invest in larger, more stable companies with less risk. You receive dividend checks quarterly, thus enjoying a stream of income that you expect to continue for a while.

The disadvantages however, are plenty, and are often overlooked by investors.

Little or No Growth

Why would a company pay a dividend? Why not use the cash to grow the company by expanding its operations? Most of the time, the answer is because it can't. Large companies typically start small, grow for a while, and eventually reach a point where further growth becomes very difficult. A company that is already very dominant in one market cannot grow very much. To do so, it would have to enter a new market, which could be very risky.

Hence, any profits that the company is making would pile up. This is the point where most companies would (and should) start paying dividends. Some companies begin even before this point, but those would typically pay a smaller dividend. For instance, in 2012 Apple (NASDAQ:AAPL) found it difficult to justify the massive amounts of cash that were building up in the bank. Despite using a lot of money on growth opportunities, the company still had too much cash to spare, so they started paying a small dividend. At the time of writing this course the dividend yield of AAPL sits at around 1.32%.

Thus, to achieve a good dividend income an investor would typically invest in companies that have little or no growth opportunities, since these are the ones with cash to spare for dividend payments. By opting for dividends, the investor forgoes possibly bigger returns and growth that other stocks might offer.

Double Risk of Dividend Cuts

In normal market conditions an income investor normally wouldn't pay attention to small price fluctuations in his dividend stocks. He's primarily invested in the stock for its dividend income, he'll be happy for any capital gains he makes on the way, and wouldn't mind a few (minor) dips in the prices of the stock. However, a dividend cut would typically cause a strong dive in the stock price. Now the investor has lost on two fronts: He will get paid a smaller dividend, and his portfolio value takes a hit from the loss in the stock price.

What is worse is that the investor is now stuck with this smaller dividend unless he is willing to exit the stock at the inferior price and realize the capital loss. A good example of this is Century Link (NYSE:CTL). In 2013 they announced a dividend cut of 25%, sending their shares plummeting about 20%. Their shares had already declined about 13% in after hours trading, meaning it would have been impossible for the average investor to exit the stock without taking a hit.

Unreasonable Avoidance of Dividend Cuts/Increases

Companies that achieve "Dividend Stock" status become very wary about adjusting their dividend in either direction. This is because once a company is considered a dividend stock, many income investors will put money into it to get the dividends. In fact, many value hedge funds don't buy stocks that don't pay dividends. Thus a dividend announcement can significantly increase a company's stock price. Apple experienced significant price increases around the time of announcing their dividend in 2012.

However, this has the opposite effect of sending the stock price plunging should the company cut its dividend. Thus companies often do everything possible to avoid a dividend cut, sometimes to the detriment of the company's business. A company might sell valuable assets necessary for business operations, or might take on extra debt just to make the dividend payment. This is obviously harmful to the company in the long run, and hence the investor should carefully check where the company is getting the cash to make its dividend payments.

Sometimes companies have the ability to increase their dividend, but don't, for fear that they won't be able to maintain the higher dividend. While this fear is often justified, other times it's not, and they end up sitting on a large amount of cash that investors could use elsewhere. Unfortunately, since the market reacts so negatively to dividend cuts, many companies opt to be safe than sorry.

Opportunity Seekers

Some companies realize the positive effects a dividend can have on the stock price and announce a dividend solely for that reason. It is the investors duty to perform due diligence on any stock that announces a dividend, to see whether the decision makes sense from a balance-sheet point of view.

Caveats & Risks in Dividend Investing

There are a number of things to watch out for when looking to invest in dividend stocks. Unfortunately some less experienced investors overlook (or forget) these things when lost in the excitement of making a new investment. We briefly discuss a few major points.

Forward Looking Markets can Blur the Picture

Markets are mostly forward looking, with less emphasis on past performance. That is, if a stock has made great profits so far but the market expects big losses soon, the stock price will tank. When the stock price decreases, the dividend yield increases due to the inverse relationship between the two (recall that the formula for the dividend yield is the annual dividend divided by the stock price).

This creates the impression that the stock is offering a very high dividend, when really this picture is likely to be temporary. The market is NOT ignoring the high dividend yield that this stock currently has, it simply believes the stock is unlikely to maintain the dividend and will likely cut it in the next quarter.

Thus there could be a period of time between two quarters where a stock's information page will show a significantly high dividend yield, but that is only a product of the large drop in the stock's price. Unfortunately, the high dividend yield combined with the price drop lures some investors into thinking this is a great deal. They invest, only to be burned after the next quarter's results when the company announces a dividend cut.

Note that sometimes price drops do create opportunities. An example of a controversial case happening right now is AT&T (NYSE:T). The price dropped recently leading to a dividend yield of over 6%. This is unusually high for such a company. In fact, AT&T's dividend yield currently sits at the top of the dividend aristocrats list. The bearish investors are mostly worried about the company's subscriber growth numbers, its debt, and a few acquisition decisions made by the management. These are all valid concerns, not to mention that Telecom is a VERY competitive industry.

The bullish optimists however, believe the billions in cash flows the company generates will be able to deal with the debt and dividends easily. They also believe AT&T's history as a dividend paying stock indicates that the management would make sure to keep paying the dividend. Furthermore, some argue that even if the company cuts the dividend, it probably would still be in the range of 4%, which is still on the high end of dividend yields.

Thus an investor's decision on whether to invest in AT&T depends on who they agree with more. Some investors think a safer option is to buy both AT&T and its main competitor, Verizon (NYSE:VZ). Both pay dividends (albeit VZ's dividend being less), and together have a very large market share. The result of buying both stocks is a dividend yield that is somewhat between the two, with the risk spread across both companies.

Deadly Cycle of Issuing Debt/Shares

This point was touched upon when talking about disadvantages of dividend investing, but must be discussed more thoroughly here. We want the dividend payments to be paid from cash flows from the company's operations. We do NOT want the company to CONSISTENTLY take on more debt or issue new shares just to pay the dividend. Both these actions can be detrimental to stockholder value in the long run. Thus, it is important for the investor to observe the cash flow statements of the company to see where the cash is coming from.

Debt has caused the fall of many giants from their thrones, including General Electric (NYSE:GE). Long considered a great dividend stock, GE faced a problem when their debt grew too much that the interest payments on their debt was consuming a large portion of their profits. As a result, they had to cut their dividend by half, which along with the drops in stock price left investors with large losses.

Kinder Morgan (NYSE:KMI) on the other hand maintained a high dividend and issued new shares whenever they needed more money. The dividend was higher than their earnings-per-share (EPS), which obviously couldn't be maintained for long. They ended up being forced to make a 75% dividend cut in 2015.

Proper management of debt/equity can make a large difference in the overall health of the company and is often reflected in the stock price. Exxon (NYSE:XOM) and Chevron (NYSE:CVX) for example had large drops in their profits for years, but were able to maintain their dividend (and even increase it) because their debt/equity was managed well, leaving them with good cash flows to fund their dividends.

Changes in Management/Strategy

Sometimes company management undergoes changes, with new CEO's and other operating officers coming in. New management could have a different outlook for the company. Perhaps they want to enter new markets or more aggressively pursue growth. An easy way to get cash for funding such plans would be to simply cut the dividend.

Note that this is NOT always a bad thing. One of the greatest investors and company leaders in the world, Warren Buffet, does NOT pay dividends. Buffett explains that investors of his company are better off today than if his company had paid dividends. This makes sense in some ways. The question is, if you are paid a dividend, what are you going to do with it? If you want to reinvest the dividend somewhere, then you might as well keep it with Buffett since he'll probably invest it better than you. Of course, if you want the dividend to spend it on your living expenses, that's a different story.

Like Buffet, some of the best CEO's and executives in the world don't pay dividends. If the dividend is very important to the investor, he should watch out for management changes in the company that might pose a risk to the dividend. An easy way to do this is to keep an eye out on the news, and research any new management that comes in.

Corporate Bonds & Other Securities

Bonds and similar securities offer an alternative place to invest that is often less risky than stocks. Many corporate bond yields are currently in the range of 3%-4% or so. Is that extra 1%-2% that the investor would make from a dividend worth the extra risk of holding stocks over bonds? This is something the investor has to think about, especially if he is in the stock primarily for the dividend and not expecting capital gains. The existence of bond alternatives can put downward pressure on dividend stocks' prices and thus the investor must keep an eye out for those.

Interest Rates

A very important metric to watch out are the interest rates. A rise in interest rates typically propagates through the markets causing rises in yield rates of bonds and other securities. This makes those securities more favorable, and thus some investors would pull out of dividend stocks and opt for the safer alternative. Typically, the market reacts to the Fed's increase/decrease of interest rates quite quickly, and the investor would do well to watch the news and read what the Fed says.

Interest rates have been recently rising after being low for so long, and this has the effect of putting downward pressure on the prices of dividend stocks. Of course, bond prices also decline when interest rates rise, so this is a metric that affects income investors in general.

Cyclical Stocks

Many cyclical stocks currently offer attractive dividend yields. Ford (NYSE:F) currently offers over 6% yield, while General Motors (NYSE:GM) sits at about 5%. The problem with both of these is the cyclical nature of their industry. We are currently in a bull market, where many cyclical stocks tend to do well. Whether they can maintain their dividends during tough economic times is another matter, one left for the investor to decide.

The current bull market has lasted for many years, and investors wary of a looming economic downturn tend to avoid such cyclical stocks (or punish them more harshly for any mistakes). Hence their prices tend to decrease, causing the dividend yields to become attractive for those willing to take a risk.

Financial News

Unfortunately when investors think about news on a stock, they think about the stock's earning report, dividend announcements, etc. The reality is that it is very important to also follow up on news about the stock's competitors as well as the industry in general. A major reason why the market has been so harsh on Ford and GM is that many investors believed Tesla (NYSE:TSLA) to be a threat to their existence. With the major technological advancements (and media hype) that put TSLA in the headlines every day, people began to wonder whether the future has a place for traditional auto stocks.

Furthermore, investors often think of a competitor's earnings report as a predictive sign of a stock's earning report. If a stock's competitor has done terribly in sales for instance, chances are the industry isn't doing well this quarter and the stock itself will likely have a bad earnings report. Thus, a savvy investors keeps his eye out for news and earning reports on competitors.

Lastly, if a stock is heavily reliant on one (or a few) major clients/suppliers, a savvy investor should do his best to watch those as well.

Fundamental Analysis

A company does not simply wake up one day and decide to cut its dividend. Typically a chain of events takes place prior to this tough decision. The investor should look at early warning signs such as a drop (or plateau) in operating income (also known as EBIT), EBITDA, and other industry-specific measures of performance.

Every industry, from airlines to consumer goods, have measures of a company's efficiency and performance, as well as other metrics the investor should watch out for. The airlines industry for instance has capacity rates, fare prices, fuel prices, etc. A thorough fundamental analysis of a company conducted periodically could signal declines in a company's performance and serve as a warning sign to an imminent dividend cut.

Typically some declining performance can cause dips in the prices of a stock, but often these won't be as severe as a drop in performance coupled with a dividend cut. If the investor anticipates the declining performance is enough to cause a dividend cut in the next quarter, he would likely be better off exiting before that happens.

As the stock trades up and down during the quarter and approaches the next earnings release, the investor could possibly find exit points that allow him to sell the stock without taking a big loss.

Dividend Aristocrats

Some companies have been so consistent in paying dividends and increasing them that they earned a title for themselves: "Dividend Aristocrats". The term "aristocrat" refers to being in the highest social class or group. Thus dividend aristocrats are considered the most noble or honorable among dividend stocks. They always pay their dividends, sometimes increase them, and almost never cut them.

Examples of dividend aristocrats include P & G (NYSE: PG), Exxon (NYSE:XOM), Coca-Cola (NYSE: KO), Walmart (NYSE: WMT), McDonald's (NYSE: MCD) and Johnson & Johnson (NYSE:JNJ). For convenience Hedge Follow offers a Dividend Aristocrats list that is updated periodically and shows the top 75 modern and traditional dividend aristocrats along with their yields.

Although they sound perfect, there are some issues with investing in dividend aristocrats that the investor should be aware of. In addition to the disadvantages and risks mentioned above that apply to all dividend stocks, here are a few issues that apply to dividend aristocrats:

Premium on Dividend Aristocrats

Holding everything else constant, a dividend aristocrat tends to be more expensive than another dividend stock with similar qualities. That is, the dividend yield for the aristocrat will tend to be a bit less. This is because investors are paying a premium for the added security and expected consistency of investing in an aristocrat. They know aristocrats are wholeheartedly committed to making and maintaining the dividend payments, and thus investors are willing to accept a lower yield.

Johnson & Johnson (NYSE:JNJ) is a famous dividend aristocrat that has been consistent for decades. Its dividend yield however currently sits at about 2.5%. This wouldn't be considered high for another dividend stock, but many are willing to settle for that with JNJ.

Dividend Aristocrats Know they are Dividend Aristocrats, and so does the Market

This fact amplifies many of the disadvantages mentioned previously. For instance, they will do everything possible to avoid losing "Dividend Aristocrat" status, including taking drastic measures (like accumulating large debt) to avoid any cuts to dividends.

Furthermore, they know they don't have to raise dividends too much to keep investors. In general, they know and understand how the market idolizes them, so any actions they take are well studied from that perspective. This means when a dividend aristocrat cuts its dividend, it already realizes the disastrous effect this will have on its stock price and still does it anyways, because it has no choice. The market also knows this, and so a cut is interpreted as an extremely bad sign and lots of stock selling ensues.

In the case of GE, they markets didn't even wait for the dividend announcement, they already anticipated a dividend cut and punished the stock severely beforehand. If a stock loses "Dividend Aristocrat" status, it is probably impossible for it to ever gain it again (without at least a decade of renewed consistency and commitment along with perhaps a change of management). Dividend investors have a strong long term memory, and will remember the pain they endured last time. Since there are alternatives with better consistency, why should they invest in a stock that has a bad recent history (and recent here means up to a decade, especially if company management hasn't changed).

Bullish/Bearing Market Effects on Dividend Aristocrats

Dividend aristocrats tends to fall somewhere between bonds and growth stocks (meaning stocks that pay no dividends at all). They are a favorite of income investors, who generally look for financial securities that provide a stream of income on a regular basis. However, there are other entities besides income investors that put money into those stocks during different market cycles.

Since dividend aristocrats tend to be bigger, more stable corporations with a large market capitalization, they are often considered safer alternatives to more volatile stocks in the market. In a bullish market when stocks are doing well and earnings are growing, money tends to flow into growth stocks and less mature stocks that show potential. Fewer investors want to settle for a small dividend yield of 2% when other stocks in the market are showing growth of about 10% or more. Some investment vehicles and funds might move some capital from dividend aristocrats to newly found opportunities.

On the other hand, during a market downturn when the bearish force comes into effect, money will tend to shift into dividend aristocrats as a safer alternative to put money as opposed to smaller companies with a less certain future. These actions can have an effect on the price levels of dividend aristocrats and the investor should be aware that some investors do use dividend aristocrats as a place to park money until a future, better paying alternative exists.

Hedge Funds and Dividend Investing

Generally hedge funds would not have dividend investing as their primary investment strategy. This is because if the fund constructed a portfolio of purely dividend stocks (with little or no growth) and achieved about 4% dividend yield, then after management and performance fees the fund's investors would receive something in the range of 2%. This is not impressive by any means, and investors generally put money into hedge funds hoping for a higher return than that (often hoping to achieve alpha and beat the market return).

Thus funds will tend to incorporate dividend stocks and aristocrats into their investment strategy as a form of diversification or value investing, but not only because of the dividend. Warren Buffet for example likes dividend stocks because he uses the cashflows from the dividend payments to fund business operations and invest in new opportunities, but he also believes in the value of the dividend stocks he invests in and hopes their price appreciates over time.

Similarly many value funds prefer stocks that pay dividends for the liquidity provided by dividend payments. For some funds, buying a stock that ends up declining in price means being stuck with a losing investment with two options. Either wait it out hoping the price increases again, or exit and take a loss. Waiting for price increases in a non-dividend-paying stock means the capital is frozen, missing out on other investment opportunities and making no return (unless the price eventually appreciates to make up for lost time). However, waiting with a dividend paying stock means collecting quarterly dividends that at least provide some return and liquidity.

Knowing all this, an income investor can look at hedge funds for clues and ideas about dividend stocks worthy of investment, but bear in mind that the dividend check isn't the only thing on their minds, in fact some activist hedge funds might be lobbying to make changes in the company strategy or management.
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