Investing in dividend stocks is often considered a smart move for novice investors. These stocks are generally seen as safer investments compared to growth stocks or non-dividend-paying companies. However, it’s important to dispel some common myths surrounding dividend stocks. In this article, we will debunk three prevalent dividend stock myths and provide you with the essential knowledge to choose better dividend stocks.
Myth 1: A high dividend yield always indicates a Good Investment
One of the most widespread misconceptions about dividend stocks is that a high yield is always a good thing. Many investors simply build a portfolio of dividend-paying equities and hope for the best. However, it’s crucial to understand that a high dividend yield may not necessarily be a healthy sign for the company.
Dividends are a percentage of a company’s income that is paid out in cash to its shareholders. If a company distributes a substantial portion of its profits to shareholders, it may indicate that management does not want to reinvest in the company. This lack of reinvestment potential can limit the company’s upside. Therefore, it’s important to consider the dividend pay-out ratio, which measures the percentage of profits distributed to shareholders. A high dividend pay-out ratio might suggest that the company is not reinvesting in its growth.
It’s worth noting that certain market sectors, such as real estate investment trusts (REITs) and master limited partnerships (MLPs), have a high payout standard built into their structure. These companies often have high pay-out ratios and dividend yields. However, it’s important to evaluate the specific dynamics of these industries before making investment decisions solely based on high dividend yields.
Myth 2: Dividend Stocks Are Boring
When we think of dividend stocks, we often associate them with utilities and other slow-growth businesses. This is because investors are often attracted to the highest-yielding securities. However, dividend stocks can become much more appealing if we shift our focus from just yield and consider other factors.
One of the strongest attributes a dividend stock can possess is the announcement of a new dividend or excellent dividend growth metrics in recent years. These announcements can be exciting developments that cause stock prices to climb and overall returns to increase. While it’s difficult to predict management decisions regarding dividends and future stock performance, there are some hints to consider.
Financial adaptability is an important factor to assess. Companies with low dividend pay-out ratios and a lot of free cash flow have the flexibility to increase their pay-outs. It’s also ideal for these companies to have low levels of capital spending and debt. On the other hand, if a company is incurring debt to maintain its dividend, it may not be a good sign.
Earnings growth, cash flow, and revenues are also important indicators to monitor. If a company is experiencing organic growth in terms of foot traffic, revenue, and margins, it’s likely that the dividend will increase in the future. The likelihood of a dividend increase may be lower if high-risk investments or global expansion are driving a company’s growth.
Myth 3: Dividend Stocks Are Always Safe Bets
Dividend stocks are often perceived as low-risk investments, especially by dividend aristocrats who have consistently increased their dividends for many years. While many dividend stocks are indeed safe and have paid out annual dividends for over 25 years, it’s important to understand that not all dividend-paying companies are safe bets.
Some companies may use dividends to pacify unhappy shareholders when their stock prices are stagnant. This is not an uncommon practise, and it’s crucial to assess how management employs dividends in their business strategy. Dividends offered to compensate for a lack of growth are almost always a bad idea.
During the 2008 financial crisis, many stocks had artificially inflated dividend yields due to stock price decreases. While these high dividend yields seemed enticing at first, numerous payout plans were eventually cancelled as profits collapsed. This led to a drop in stock prices, particularly for bank equities. Therefore, it’s important not to solely rely on dividend yields as a measure of investment attractiveness.
How to Choose Better Dividend Stocks
Now that we have debunked the common myths surrounding dividend stocks, let’s explore some key criteria to consider when choosing dividend stocks to enhance your investment decisions.
1. Dividend Yield and Total Return
Dividend yield, when combined with total return, can be an important factor to consider. Dividends are typically expected to increase the total return of an investment. However, it’s crucial to look beyond just the dividend yield and evaluate other aspects of the company’s financial health.
2. Dividend Pay-out Ratio
The dividend pay-out ratio is a key metric to monitor, as it reveals whether a company can reinvest and expand its business. A high dividend pay-out ratio may indicate a lack of reinvestment potential, while a low ratio coupled with substantial free cash flow can suggest flexibility to increase pay-outs.
3. Earnings Growth, Cash Flow, and Revenues
Monitoring a company’s earnings growth, cash flow, and revenues can provide insights into its ability to sustain and potentially increase dividends. Organic growth and strong financial performance are positive indicators for dividend growth.
4. Industry Dynamics
Understanding the dynamics of the industry in which a company operates is crucial. Some industries, like REITs and MLPs, have high pay-out ratios built into their structures. Evaluating the specific characteristics and risks of these industries will help you make informed investment decisions.
5. Management’s Dividend Strategy
Assessing how a company’s management employs dividends in their business strategy is essential. Dividends should not be used as a band-aid to compensate for lacklustre stock performance or a lack of growth. Look for companies that have a clear commitment to dividend growth and a track record of responsible dividend management.
6. Dividend History and Dividend Aristocrats
Examining a company’s dividend history can provide insights into its commitment to shareholders. Dividend aristocrats, which are companies that have increased their dividends every year for the past 25 years, are often seen as safe investments. However, it’s important to analyse other financial metrics alongside the dividend history to make well-informed decisions.
7. Fundamental Analysis
Conducting fundamental analysis is crucial when selecting dividend stocks. This involves evaluating a company’s financial statements, competitive position, management team, and industry trends. Fundamental analysis helps investors assess the intrinsic value of a company, its growth potential, and its ability to sustain and grow dividends.
Diversification is key to reducing risk in any investment portfolio. Investing in a variety of dividend stocks across different industries and sectors can help mitigate the impact of any individual stock’s performance on your overall portfolio. Diversification spreads risk and increases the chances of finding successful dividend stocks.
9. Long-Term Perspective
Investing in dividend stocks requires a long-term perspective. Dividends provide a steady stream of income over time, and their compounding effect can significantly enhance total returns. Patience and a focus on long-term wealth creation are essential when investing in dividend stocks.
10. Professional Guidance
If you are unsure about selecting dividend stocks or want expert advice, consider seeking professional guidance from financial advisors or wealth managers. They can provide personalised recommendations based on your financial goals, risk tolerance, and investment horizon.
In conclusion, dividend stocks can be a valuable addition to an investment portfolio. However, it’s crucial to dispel common myths and make well-informed decisions based on key criteria such as dividend yield, dividend pay-out ratio, earnings growth, industry dynamics, and management’s dividend strategy. Conducting fundamental analysis, diversifying your portfolio, and maintaining a long-term perspective are essential for successful dividend stock investing. Remember, professional guidance can also provide valuable insights to enhance your dividend stock investing strategy.