If you’re already investing in some of the low-cost ETFs we’ve highlighted on our site, chances are, you’re already invested in some dividend-paying stocks.
A reminder you can find some of the best diversified ETFs to own for your portfolio here.
But what if you wanted to own a few individual stocks along with your ETFs? Is that wrong from an investing perspective? Are there risks in owning individual dividend stocks?
Is Dividend Investing Right for You?
This post will help you decide so please read on!
What is a dividend?
The word dividend has Latin origins; dividendum (“thing to be divided”).
Quite simply, a dividend is money in your pocket.
More technically, a dividend is a payment of a company’s profits distributed to shareholders and usually paid quarterly, or monthly. That’s what gets “divided” to you, a portion of the corporation’s cash flow from net income.
Unlike the company’s share price, which can change from day to day, once a company or the Board of a company commits to paying a dividend, it will get paid to you.
Dividends are a way for shareholders to participate and share in the growth of an underlying business – because as a shareholder of the company – you own a portion of it.
While there are different types of dividends per se (cash dividends, which are cash payments to shareholders) and stock dividends (a percentage increase in the number of shares owned), this post will largely focus on cash dividends since that’s how most corporations in Canada reward shareholders.
When you own dividend-paying stocks, and those companies pay out dividends to you as a shareholder, you are essentially receiving some of its retained earnings that a company has already created through its cash flow and profit-making activities.
It’s important to note when dividends are paid, the effect on the balance sheet is a decrease in the company’s retained earnings and its cash balance. In other words, retained earnings and cash are reduced by the total value of the dividend. That may or may not appeal to all investors. Shareholder value is created in many ways!
What do you mean, shareholder value is created in many ways?
Paying a dividend is not the be-all, end-all.
Take a look at this chart. This is Shopify, one of the largest tech companies in Canada.
Source: Google on 2021-05-05 pm.
Wouldn’t you have loved to own a few thousand shares in Shopify in 2010, or even since 2016 which is 5-years ago and held to this day? We feel the same at Cashflows & Portfolios!
Shopify doesn’t pay a dividend at all.
Dividends are just one way Boards can reward shareholders. Shareholder value may also occur via other smart money management moves as this chart from Shopify illustrates:
- Companies can pay down debt, and be more “cash-rich”.
- They can acquire other companies, onboarding new products or services to customers.
- By not paying a dividend and investing those earnings back into the business (like Shopify has), the company can improve upon their menu of value-added products and services that consumers want to buy, use, and will pay more money for.
- Companies can merge with other companies, to gain larger market share or competitive advantages.
- They can buy back shares, increasing shareholder value of shares currently owned since fewer shares are outstanding to buy in the marketplace.
- And other moves….
The point is, there are many ways to increase the value of a company for shareholders over time. Paying dividends to shareholders might be just one attractive feature.
Why might some companies pay a dividend?
Because dividends are typically a sign of financial health, a company may offer them to attract investors and drive the share price up (over time). We believe, based on our own experiences with investing in dividend-paying stocks, that if a company commits to paying a dividend and increasing their dividend, it’s usually a sign of a more stable company.
Generally, companies pay dividends when money is left over after covering key operating expenses and business reinvestments. That’s why mature companies, which require less capital reinvestment such as tech start-ups, are much more likely to pay a dividend.
But there is another reason that My Own Advisor has written about on his site when it comes to the attractiveness of dividends – it provides “optionality”.
We already shared above that dividend-paying companies can attract a certain type of investor; one who prefers cash in hand versus the hope of capital gains. Companies know there are many investors out there who put a bias on income generated from their portfolio over growth.
But in a perfect, rational world, all businesses would allocate capital in a way to perfectly maximize the return on that capital. This would be done so reinvested money would go back into the business in a way that pays off immensely for the shareholder (by increasing returns over time AND by continually reducing the company’s tax burden). However, we don’t live in a perfect world. We cannot predict the future. We don’t always know if share buybacks or reinvestments into the business or new acquisitions will ultimately turn out to be the best financial decisions for the company or shareholders long-term.
So, we have dividends and dividends provide “optionality”. Shareholders like optionality because this means choice. Dividends offer choices to investors to increase or decrease their exposure to the business. Reinvested dividends can take advantage of that optionality, to increase exposure. Dividends taken as cash, do not. Dividends taken as cash by a shareholder like you, is yours to save, spend or deploy as you wish.
While no dividends are ever guaranteed, even by the best and most established companies that pay dividends, you should know there is also a pecking order for payouts.
If a company is forced to cut its dividend (like Canadian energy giant Suncor had to do last year – to preserve earnings), it starts with bond holders, then preferred shareholders and, if there’s anything left over, give common shareholders their due.
While there may also be “special dividends” offered now and again (like a paycheck bonus at work if you’re lucky to get one!), these one-time payouts are just that and should be treated as such.
If you’re a dividend investor, you typically want to be paid on a predictable schedule. That’s part of the process you’re buying into.
Why might some companies not pay dividends?
A young, rapidly growing company (in our example above, a young tech company) often needs to reinvest all its available capital to fuel growth. So, you’ll probably find most start-ups, younger companies in general, really can’t afford to pay a dividend.
Conversely, even a mature company (like the famous Berkshire Hathaway) may also avoid paying a dividend since they have other ways to create shareholder value – like the options we mentioned above. It should be noted that even enough Berkshire has never paid a dividend to shareholders, it owns many dividend-paying companies and always has!
Is Dividend Investing Right for You?
Given not all great, growing companies that may deliver high returns may never pay a dividend, does it even make sense to focus on just dividend-paying stocks – and avoid the rest in your portfolio?
Even though dividends aren’t guaranteed, even though only some dividend-paying companies will thrive long-term, there are two key reasons we believe many investors rely on dividend-paying stocks (like we have in part) to invest in:
- Some investors love income! A dividend payment is real cash, real money paid out to you as a shareholder you can spend or save or invest more with as you please. Further, by taking advantage of dividend reinvestment plans (something we’ll discuss more on our site over time), investors can put any dividends to work by reinvesting that cash to buy more shares. Dividend reinvestment plans automate this process: dividends are paid, if you have enough to reinvest in the company you get more shares, then more dividends are paid next time after dividends are declared. Essentially your money that makes money can make more money over time. Compounding income in action!
- Some investors can save themselves from themselves! With a dividend payment, that is real cash, real money paid out to you as a shareholder, it can help you psychologically. That income stream can help you avoid selling your stocks, at inopportune times, when the stock markets are tanking. Because you are getting paid, you can avoid making knee-jerk reactions if a company has a bad month or quarter, for example, and the stock price drops in response. If the stock price drops, you can be strategic with your dividend payment if you’re not already reinvesting the dividends to buy more shares – since you can now buy more shares at deflated prices. Don’t want to buy more shares when the prices are lower? No problem, you can always take that dividend money and diversify elsewhere, buy something else that fits your plan. That could be low-cost ETFs for extra diversification. The point here is that dividends can be a strategic way to get paid to wait and/or when you do get paid to find other investments at opportunistic times.
Summary – Is Dividend Investing Right for You?
While there are many pros and cons of this investing approach, more than one post could include, we believe dividend investing can offer investors with sound temperament and discipline, some outstanding income results over time.
Both of us are actually proof of that process in action.
We (Mark and Joe), the founders of this site, have used dividend investing (along with owning low-cost ETFs) to start from scratch to build significant 7-figure portfolios – that are leading the way to our respective financial independence.
We can say with confidence though that dividend investing or dividend growth investing is not for everyone.
It can take time to manage a portfolio. There are commission costs that may be incurred to buy the individual stocks. There is certainly some concentration risk. Meaning, if you’re just looking at owning dividend paying stocks, you are largely ignoring thousands of other wealth-building companies (that you could own by index investing).
But this approach when used wisely, with discipline, can be personally and financially rewarding.
We believe only you can ultimately answer if this income-oriented approach will work for you.
While dividend-paying stocks and dividends can have a major role in any portfolio, this is by far and away not the only way to invest or build wealth.
Further Reading: When Should I Start Investing?
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Thanks for your readership!