Dividend Paying Stocks, ETFs And Mutual Funds

| May 12, 2008 | 0 Comments

Traders have it easy.  They buy into a stock and get out of it very quickly.  All day long they buy and sell, buy and sell.  At the end of the day they tally up the profits and losses and they know how well they’ve done.  It’s a good day when they’ve got more money than they started with.

The problem with trading is not everyone has the time or patience.

To be a market trader you need to spend your entire day watching the markets.  Traders by their very nature are focused on the short term. Almost everyone else focuses on the long term.  Most investors are of the “Buy and Hold” variety.

These long term investors aren’t focused on the next few days.  They’re looking years and in some cases decades down the road.  You might even be one of them.  Because you’re focused on the long term you have a unique set of challenges.

The 10% rule of thumb.

I’m sure you’ve heard this before.  As a rule of thumb, markets return on average 10% per year.  Brokers love to quote it, investors talk about it, even as an investment banker I used it a time or two.  This data point is referring to a very long term average.  Like anything sometimes you do better and sometimes you do worse.

Most people don’t know this important fact.  The 10% return isn’t always from prices going up.  A portion of this long term average return is from dividends.

Dividends play a very important role in most long term investment strategies.

I recently read a study analyzing stocks.  What they found was amazing. Investors captured a better return from one particular group of stocks. Companies that paid a dividend and consistently increased that dividend provided a better return than all other stocks.

The performance was increased by almost 2.2%.

I know that doesn’t seem like much.  But remember, we’re looking at long term buy and hold strategies.  The difference of 2.2% over 30 years is substantial.  For an investment as little as $100 the 2.2% difference amounted to over $1,800 in 30 years!

When a company pays dividends it highlights the company’s health. Increases in the dividend show the Board of Directors is confident in the future of the company.  Clearly, owning dividend paying stocks is important to most investment portfolios.  But, you can’t just rush out and buy any stock that pays a dividend.

It’s important to find dividend paying companies with strong financials. The first two things I look at are the dividend history and the payout ratio.

I like to see companies with long histories of paying dividends.  I like to see 10 to 20 years, or more.  This is a sign management knows how to run the business through all types of economic cycles – both good and bad.  A company that can consistently send dividends to its shareholders speaks to the stability and strength of the company.

The second data point I look at is the payout ratio.

The payout ratio is simply the amount of a company’s earnings that are being sent to the shareholders.  It’s normally expressed in terms of a percentage.  So a company with a 45% payout ratio sends 45 cents of every dollar it earns to shareholders.

The payout ratio can highlight a big red flag.  If I see a company’s payout ratio close to 100%, I tread very carefully.  Companies that send out a significant amount of their earnings in dividends may be looking to cut those dividends soon.

On the other hand, the payout ratio can also toss up a big green flag.  If a company has a really low payout ratio, this might signal the board is about to raise dividends.  And that can be a great time to buy.

Just having a strong dividend isn’t foolproof.  Just look at all of the financial stocks that have recently cut their dividends.

So, how do we invest for dividends?

If you want to take the time, and you have a big enough portfolio, you might look at individual stocks.  Make sure to diversify and remember to closely monitor your selections.

An easier way is to buy a mutual fund focused on dividend stocks, or maybe an ETF.  You all know how much I like ETFs.  iShares has a dividend focused ETF matching the Dow Jones US Select Dividend Index (DVY).  This fund invests in US based companies.  They look closely at dividend growth rates, payout percentages, and yields, among other factors.  It’s a convenient way to buy a basket of dividend paying stocks and capture a great yield of over 4.5%.

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Category: Dividend Stocks

About the Author ()

The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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