Understanding dividends

Stock dividends are important — but not all are created equal. It’s essential to remember that the percent your stock is paying is something to be aware of, but paints only a small part of the picture. Since April is Financial Literacy Month, let’s take this opportunity to get to know dividends!

As a component of total return

Let’s examine a stock investment strategy that uses dividends as a component of total return. According to data from Morningstar/Ibbotson, dividends have contributed 42% of the annual average total return of the S&P 500 index from 1926 through 2018. Some stocks may pay none, while others pay a very high dividend. This strategy eliminates the stocks that pay no dividend. In most cases, the very high dividend payer will be eliminated also. An unusually high dividend may indicate a problem.

Portfolio strategies

One potential focus is on stocks that pay dividends; those that are sustainable with an ability to increase on a regular basis. Here, “sustainable” simply means the company has the financial stability to pay the dividend through a variety of economic periods. This requires that company to continue to grow. As you would expect, the companies represented in this type of portfolio tend to be established companies that generate free cash flow, and exhibit management styles that work toward growth.  Another focus is to invest in stocks in various industries to help diversify the portfolio. It’s not uncommon to have a portfolio of up to about 50 stocks.

An example over time

Let’s assume you purchased a stock like Clorox Company at the peak of the 2007 market. You would have paid about $62 per share and your quarterly dividend was 40 cents per share. That would equal an annual dividend of over 2.5%. Fast forward to March 2019 and the stock price is $158 per share and a dividend of $.96 per quarter. That is about a 2.4% yield based on the current price. However, keep in mind if you purchased the stock in 2007 at $62, you’re getting over 6% on the money you invested just in dividends. Additionally, you saw the share price rise significantly.

To be sure, as the market experienced a decline in 2007, you watched your investments drop by ~20%. As long as you understood what you owned and were not panicked into selling, this was a wise investment. This is not a specific recommendation — but rather, an example of how a stock that pays and increases dividends can work.

Volatility and turnover

Over time, the strategy may include reducing, increasing, adding and/or eliminating holdings in the portfolio. The fundamental strategy remains the same and tends to have a low/moderate turnover (amount of trading) in the portfolio. These stocks will still experience market volatility, although sustainable dividends tend to have more support than non-dividend payers. Conversely, in times of higher growth, even stocks with no dividend may outperform this strategy.

How to utilize a dividend strategy

You can utilize this strategy using funds, Unit investment trusts, or individual stocks. This is only one of multiple strategies that are available. Like all investments — you should fully understand the details before you begin, and work with a financial advisor. For more details and questions on this and other investment opportunities, feel free to contact me!

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