When a company becomes mature, a smaller percentage of profits must be reinvested to fund research, growth of the company, and marketing. This leaves money for the company to pay out in dividends – payments of a portion of the profits of the company directly to investors. This is the ultimate reason that people buy companies since, without dividends, investors would never receive any of the profits of the company.
Many investors think that dividends are not important since they make their money selling stocks and capturing a capital gain, but if the company was going to reinvest forever, or just keep growing salaries of the executives and the workers and never pay out any money to the stockholders – the owners of the company – there would be no reason to buy the shares and make the price increase. Indeed, even for companies that pay no dividend, investors are paying more for the company as earnings increase because they expect to get a good return on their investment at a latter date. That reward comes in the form of a dividend.
Realize also that the yield percentage you see today is only part of the picture. (Note that the percentage of profits paid out in the form of a dividend is called yield, while payments from a bank account or a bond are called interest and the percentage paid the interest rate.) When you buy a stock, you are effectively locking in the amount you are committing, so your yield is based on the amount you invested even if the price of the company increases. If you buy a company with a 1% dividend, that may not seem exciting compared to bonds paying 6% interest or even some long-term CDs paying 2% interest.
If the company is growing, however, and the dividend is increasing by 15% per year, the dividend will double every five years. So in five years, that dividend becomes 2%, in 10 years it is 4%, and in 15 years it is 8%. At that point your shares in a solid company are paying more than many junk bonds, but you also have the prospect for growth of the company (and future growth of the dividend). The price of the stock may have doubled each time the dividend did, meaning the company is still only paying out a 1% dividend, but to you the yield is 8%. You could also choose to sell your stock and realize the large capital gain you’ve received as well.
That said, young people with a long time to invest shouldn’t concentrate their money in dividend paying stocks. These companies tend to be large, well-established companies that just can’t grow as fast as younger companies because of their size. (Think about how difficult it would be for Coca-Cola to double their sales, versus a restaurant chain with 50 locations.) You will do a lot better over time buying smaller companies with room to grow than large companies that have started to stagnate.
Still, for those who need the income these stocks provide to pay for living expenses or supplement job income, income stocks are a good buy. If your stocks are paying enough in dividends to meet your spending needs, there is no need to sell shares each time you need to raise cash. You also don’t need to worry about selling shares at low prices after a fall to raise cash. You will be unaffected as long as economic conditions don’t become so bad so as to cause companies to cut dividends.
They should also make up a portion of most portfolios since income stocks add stability. This is because the percentage yield provided by the dividend increases as the stock price goes down (because the dollar amount of the dividend remains fixed), eventually getting to the point where buyers come in and help prevent the stock price from falling further. In doing so, they are getting more income from dividend stocks than they can elsewhere. This means that a portfolio full of income stocks will not fall as far as one filled with growth stocks. A holder of dividend paying stocks will also be getting a return from the dividends even during stagnant periods when stock prices are not increasing, This takes a little of the bite off of drops in the markets and helps increase returns during down markets or stagnant markets. During boom times, however, growth stocks will provide returns several percentage points above those of income stocks. Those who have longer investment horizons, and therefore can wait for the boom times to come, and those who don’t need a regular stream of income should limit the percentage of income stocks in their portfolio to their age or less to increase their total returns.
To find income producing stocks, just look for those with a relatively high dividend. Be wary of those that have very high dividend compared to other stocks because this may be a company that is having financial troubles, causing the price of the stock to decline. Such a company may well cut their dividend in the near future. Traditionally heavily regulated industries like utilities are good sources of income stocks because the regulators allow the company to generate a certain profit level and if needed raise their prices to maintain that profit level. Their products also tend to be things people need to buy no matter what and there is little competition. Other income stocks are the large, household-name companies. If you buy several of their products a month, so do a lot of other people, so they will probably be generating a lot of income and can pay out a portion as a dividend.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.