Put Dividends to Work for You in Your Investment Portfolio

It was considered laughable during the dotcom boom of the late 1990s to be investing in dividend paying stocks. Back then, everything was increasing by double-digit percentages, and no one wanted to be the recipient of a meager 2 percent dividend increase. After the stock market’s bull run in the 1990s came to an end, dividends became once again attractive.

Dividend-paying stocks have become increasingly attractive to many investors in recent years. Despite several market booms since the 1990s, “boring” dividend stocks continue to be one of the best investment opportunities for regular investors.

The Most Important Takeaways

  • Dividends are cash payments made by a corporation to its stockholders in exchange for a portion of the corporation’s profits.
  • When a company chooses not to pay dividends from its profits, it is indicating that the company prefers to reinvest the profits in new projects or acquisitions.
  • The decision to begin paying dividends is frequently made by a company when its rate of growth has slowed.
    Once a company begins paying dividends, it is highly unusual for it to discontinue the practice.
  • When it comes to increasing the stability of an investment portfolio, dividends are an excellent choice because the periodic cash payments are likely to continue for a long period of time.

What are Dividends and How Do They Work?

In the business world, dividends are payments made from a company’s profits in cash. It is announced by the board of directors of a company and distributed to its stockholders as part of the annual meeting. In other words, dividends are a shareholder’s share of a company’s profits that are distributed to them as a result of their ownership interest in the company. Dividends, with the exception of option strategies, are the only way for investors to profit from their stock ownership without having to sell their entire stake in the company.

Whenever a company generates profits from its operations, management has two options: either retain the profits, essentially reinvesting in the company in the hope of generating even more profits and thus further stock appreciation, or distribute a portion of the profits to shareholders in the form of dividends. Dividends are paid out to shareholders when a company generates profits from operations. Management can also choose to repurchase some of its own stock, which would be beneficial to both the company and its shareholders.

In order to justify reinvesting in itself rather than paying a dividend, a company’s growth rate must be above average for an extended period of time. Generally speaking, when a company’s growth slows, its stock price will not rise as much, and dividends will be required to keep shareholders interested in the company. After reaching a certain level of market capitalization, virtually all companies experience a slowdown in their growth. The size of a company will simply reach a point at which it no longer has the potential to grow at annual rates of 30 percent to 40 percent, as in the case of a small cap, regardless of how much money is plowed back into the company. Once you reach a certain size, the law of large numbers makes the combination of a mega-cap company with growth rates that outperform the market an impossibility.

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In addition to serving as a signal that the stock’s growth rate has begun to slow, dividend payments also serve as a signal that the company is healthy enough to ensure that its investors receive regular payments.

Microsoft and Apple : Together once more.

The changes that occurred at Microsoft in 2003 are a perfect illustration of what can occur when a company’s growth slows or stops altogether. Microsoft finally announced that it would pay a dividend in January 2003, citing the fact that the company had amassed so much cash that it couldn’t find enough worthwhile projects to invest it in. After all, a high-flying growth stock cannot be sustained indefinitely.

The fact that Microsoft began to pay dividends did not portend the company’s demise, as some had speculated. Instead, it indicated that Microsoft had grown into a massive corporation and had reached a new stage in its life cycle, which meant that it would likely not be able to double and triple its revenue at the same rate as it had in the past. Microsoft announced in September 2018 that it would be increasing its dividend by 9.5 percent, to 46 cents per share, effective immediately.

The same story played out at Apple as well. Apple has long positioned itself as the anti-Microsoft, and the company has no better use for its cash than to reinvest it back into the business or to make acquisitions to further its position. Apple, on the other hand, began paying a dividend in 2012 and in 2017 surpassed dividend darling Exxon to become the company with the largest dividend payout in the world. At the end of November 2018, Apple paid a dividend of 73 cents per share to its shareholders.

Dividends Will Never Lead You Astray

It can be argued that by opting to pay dividends, management is essentially acknowledging that profits from operations are better off being distributed to shareholders rather than reinvested back into the business. Therefore, management believes that reinvesting profits to achieve further growth will not provide shareholders with a return that is comparable to that provided by dividend payments to the shareholders.

An additional motivation for a company to pay dividends is the perception that a steadily increasing dividend payout is an excellent indicator of the company’s long-term viability and success. Among the many advantages of dividends is the fact that they cannot be manipulated; they are either paid or not paid, and they are either increased or not increased.

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Unlike earnings, which are essentially an accountant’s best guess at a company’s profitability, this is not the case with earnings. Companies are forced to restate their past reported earnings far too frequently as a result of aggressive accounting practices, which can cause significant headaches for investors who may have already made future stock price predictions based on these unreliable historical earnings.

Growth rates that are predicted are also unreliable. There is no guarantee that a company will make the most of its reinvestment of earnings, even if it talks a big game about fantastic growth opportunities that will pay off several years down the road. When a company’s ambitious plans for the future (which have an impact on its stock price today) do not materialize, your portfolio will almost certainly suffer a setback.

Rest assured that no accountant will be able to restate dividends and force you to return your dividend check to the company. Furthermore, dividends cannot be squandered by the company on business expansions that do not prove successful in the end. The dividends that you receive from your stocks are entirely yours to keep and invest. You can use them to do whatever you want with them, such as paying down your mortgage or spending them as extra money.

Who is in charge of determining dividend policy?

The company’s board of directors determines what percentage of earnings will be distributed to shareholders and then reinvests the remainder of the profits back into the company’s operations. Despite the fact that dividends are typically paid out on a quarterly basis, it is important to remember that the company is not required to pay a dividend every single quarter. In fact, the company has the ability to discontinue dividend payments at any time, but this is extremely rare—particularly for a company with a long history of dividend payments.

Investors who have become accustomed to receiving their quarterly dividends from a mature company would suffer a financial catastrophe if the company were to suddenly cease dividend payments to them.

The decision to discontinue dividend payments would be indicative of a fundamental problem with the company unless it was accompanied by some kind of strategic shift, such as investing all remaining earnings in profitable expansion projects. As a result, the board of directors will usually go to great lengths to ensure that the dividend amount remains at least the same.

How Dividend-Paying Stocks and Bonds Are Comparable

Consider the volatility and performance of dividend-paying stocks in comparison to outright growth stocks that do not pay dividends when weighing the advantages and disadvantages of dividend-paying stocks.

Because public companies are generally subject to negative reactions from the marketplace if they discontinue or reduce dividend payments, investors can be reasonably certain that they will receive dividend income on a consistent basis for as long as they hold their shares of stock in public companies. Because of this, investors tend to rely on dividends in the same way that they rely on interest payments from corporate bonds and debentures to supplement their income.

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Dividend-paying stocks, because they can be thought of as quasi-bonds, tend to have pricing characteristics that are only marginally different from those of growth stocks. The reason for this is that they provide regular income that is comparable to that of a bond, while also providing investors with the possibility of profiting from share price appreciation if the company performs well.

Consider adding stocks with high dividend yields to their portfolio if you want exposure to the growth potential of the stock market while also having the security of (moderately) fixed income provided by dividends in your investment portfolio. A portfolio consisting primarily of dividend-paying stocks is likely to experience less price volatility than a portfolio consisting primarily of growth stocks.

Understand the dangers

The payment of dividends is never guaranteed, and they are subject to the same risks as share prices, including company-specific and market-related risks. During times of turbulence, management will be forced to make a decision about what to do with the company’s dividend payments.

Take, for example, the banking industry during the financial crisis of 2008-2009. Prior to the financial crisis, banks were well-known for paying out large dividends to their stockholders. Initially, investors viewed these stocks as stable and yielding a high rate of return. However, when the banks began to fail and the government intervened with bailouts, dividend yields soared while stock prices plummeted.

Taking Wells Fargo as an example, the bank offered a dividend yield of 3 percent in 2006 and 2007 before increasing it to 4.5 percent in 2008. In 2009, the bank was forced to reduce its dividend from 38 cents per share to 5 cents per share.

What’s the bottom line?

A company cannot continue to grow indefinitely. When a company reaches a certain size and has exhausted its growth potential, paying dividends to shareholders is perhaps the most effective way for management to ensure that shareholders receive a return on their investment in the company. The declaration of a dividend may be a sign that a company’s growth has slowed, but it is also evidence of the company’s ability to generate profits in the long run.

When distributed as dividends on a regular basis, this reliable source of income will almost certainly contribute to some degree of price stability. The best part is that the cash in your hand is tangible proof that the earnings are real, and you can use it to reinvest or spend the money as you see fit.

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