During the dotcom boom of the late 1990s, the notion of dividend investing was laughable. At the time, everything was growing in double-digit percentages, and no one wanted to see a measly 2% gain from dividends. After the bull market of the 1990s ended, dividends became attractive again.
For many investors, stocks paying dividends have become very logical. Although we have seen several market rises since the 1990s, “boring” dividend stocks remain one of the best opportunities for regular investors.
Key points to remember
- Dividends are cash payments made by a company to its shareholders based on the profits of the company.
- If a company does not pay dividends on its profits, it means that it chooses to reinvest the profits in new projects or acquisitions.
- A company often chooses to start paying dividends when its growth rate has slowed.
- Once a company starts paying dividends, it is very atypical for it to stop.
- Dividends are a good way to provide additional stability to an investment portfolio, as periodic cash payments are likely to continue over the long term.
What are dividends?
A dividend is a cash payment from the capital of a company earnings. It is announced by a company’s board of directors and distributed to shareholders. In other words, dividends are an investor’s share of a company’s profits and are paid to him as a co-owner of the company. Other than options strategies, dividends are the only way investors can profit from stock ownership without eliminating their stake in the company.
When a company earns profits from its operations, management can do one of two things with the profits: they can choose to keep them, essentially reinvest into the business with the hope of creating more profits and therefore greater stock appreciation, or it may distribute part of the profits to shareholders as dividends. Management can also choose to buy back some of its own shares, a move that would also benefit shareholders.
A company must continue to grow at an above-average rate to justify reinvesting in itself rather than paying a dividend. Generally speaking, when a company’s growth slows, its stock will not rise as much and dividends will be needed to keep shareholders. The slowdown in this growth happens to virtually all companies after they have reached a large market capitalization. A company will simply reach a size at which it no longer has the potential to grow at annual rates of 30-40%, such as a small cap, regardless of how much is reinvested into it. At some point, the law of large numbers makes a mega-cap company and above-market growth rates an impossible combination.
While paying dividends is usually a sign that a stock’s growth rate has started to slow, it’s also a sign that a company is healthy enough to ensure that its investors receive regular payments.
Together again: Microsoft and Apple
The changes seen at Microsoft in 2003 are a perfect illustration of what can happen when a company’s growth plateaus. In January 2003, the company finally announced it would pay a dividend: Microsoft had so much cash in the bank that it simply couldn’t find enough worthwhile projects to spend it on. After all, a high flight growth stock can’t last forever.
Just because Microsoft started paying dividends didn’t spell the end of the company. Instead, it indicated that Microsoft had become a huge company and had taken another step in its cycle of life, which meant he probably wouldn’t be able to double and triple at the rate he once did. In September 2018, Microsoft announced that it was increasing its dividend by 9.5% to 46 cents per share.
This same story happened at Apple. Apple has long positioned itself as the anti-Microsoft with no better use for the money than reinvesting it in the company or in acquisitions. In 2012, however, Apple began paying a dividend and surpassed the darling Exxon dividend in 2017 to pay the biggest dividend in the world. As of July 28, 2022, Apple was paying shareholders a dividend of 23 cents per share.
Dividends won’t mislead you
By choosing to pay dividends, management is essentially conceding that it is better for operating profits to be distributed to shareholders rather than reinjected into the business. In other words, management believes that reinvesting earnings to pursue growth will not provide the shareholder with as high a return as a dividend distribution.
There is another motivation for a company to pay dividends: A steadily increasing dividend payout is considered a strong indication of a company’s continued success. The great thing about dividends is that they can’t be rigged; they are paid or unpaid, augmented or unaugmented.
This is not the case with earnings, which are essentially an accountant’s best estimate of a company’s profitability. Too often, companies have to restate their reported past earnings due to aggressive accounting practices, which can cause considerable problems for investors, who may have already based their future price predictions on these unreliable historical earnings.
Expected Growth rates are also unreliable. A company can talk about great growth opportunities that will pay off for several years, but there is no guarantee that it will make the most of its reinvested earnings. When a company’s robust plans for the future (which impact its share price today) don’t materialize, your portfolio will most likely take a hit.
However, you can rest assured that no accountant can restate dividends and take back your dividend check. Additionally, dividends cannot be wasted by the company on business expansions that do not materialize. The dividends you receive from your shares are 100% yours. You can use them to do whatever you want, like paying off your mortgage or spending it like discretionary income.
Who determines the dividend policy?
The company’s board of directors decides what percentage of profits will be paid out to shareholders and then funnels the remaining profits back into the company. Although dividends are generally distributed quarterly, it is important to remember that the company is not obligated to pay a dividend every trimester. In fact, the company can stop paying a dividend at any time, but that’s rare, especially for a company with a long history of paying dividends.
If people were used to receiving their quarterly dividends from a mature company, a sudden halt in payments to investors would spell financial disaster for the company. Unless the decision to stop paying dividends is supported by some kind of change in strategy – say invest all retained earnings in robust expansion plans – this would indicate that something was fundamentally wrong with the business. For this reason, the board will generally strive to continue to pay out at least the same amount of dividend.
How Dividend-Paying Stocks Look Like Bonds
When weighing the pros and cons of dividend-paying stocks, you’ll also want to consider their volatility and the performance of the stock price relative to that of outright growth stocks that pay no dividends.
Since public companies generally face adverse market reactions if they halt or reduce their dividend payments, investors can be reasonably certain that they will receive dividend income on a regular basis for as long as they hold their shares. . Therefore, investors tend to rely on dividends the same way they rely on interest payments from corporate bonds and debentures.
Since they can be considered quasi-bonds, dividend-paying stocks tend to exhibit slightly different price characteristics than growth stocks. In effect, they provide regular income similar to a bond, but they still offer investors the opportunity to benefit from share price appreciation if the company is doing well.
Investors seeking exposure to the growth potential of stock market and the security of (moderate) fixed income provided by dividends should consider adding stocks with high dividend yields to their portfolio. A portfolio of dividend-paying stocks is likely to experience less price volatility than a portfolio of growth stocks.
Know the risks
Dividends are never guaranteed and are subject to company-specific and market-related risks, just like stock prices. In turbulent times, management will have to decide what to do with its dividends.
Take the banking sector during the financial crisis of 2008-2009. Before the crisis, banks were known to pay high dividends to their shareholders. Investors saw these stocks as stable with high yields, but when banks started failing and the government stepped in with bailouts, dividend yields jumped while stock prices fell. For example, Wells Fargo offered a dividend yield of $0.26 to $0.28 per share in 2006 and $0.28 to $0.31 per share in 2007, but increased it to $0.31 to 0. .34 dollars per share in 2008. The bank was forced to lower its dividend from 0.38 to 0.05 dollars. in 2009.
The essential
A business cannot continue to grow indefinitely. When it reaches a certain size and exhausts its growth potential, the distribution of dividends is perhaps the best way for management to ensure that shareholders receive a return from the company profit. A dividend announcement can be a sign of a company’s slowing growth, but it’s also evidence of a sustained ability to earn money. This sustainable income will likely produce some price stability when paid out regularly in the form of dividends. Even better, the cash you have on hand is proof that the earnings are really there, and you can reinvest them or spend them as you see fit.