Investing In Dividends for Passive Income

By | December 10, 2012

Investing in dividends are a great way to increase your wealth and passive income. As a dividend investor you gain in two ways: the appreciation of the stock and dividend income. Investing in dividends gives a risk adverse investor a great way to lock in gains, as a bad quarter can erase any unrealized gains in a stock price. Dividends can occur annually, bi-annually, monthly, or quarterly, depending on the company, but they are usually given out quarterly. Before you start investing aggressively to chase that dividend yield, here are a few tips to successful dividend investing.

1. Historical Dividend Payout

Dividends are a privilege, not a right. Companies issue out dividends as an incentive for investors to hold on to the stock. Whenever a company runs low on cash, or their debt payments are two high, usually what the managers of the company do is cut dividends to save cash. Companies in cyclical industries are especially susceptible to this, and in times of economic hardship companies usually do things to reduce expenses like layoff workers, sell of less profitable assets, and cut dividends. But dividend cuts can happen for a variety of other reasons. Although you can never know for certain if a company will issue a dividend before they announce it, you can look at a company’s track record to see if they have paid their dividends on time.

2. Is There a Track Record of Dividend Growth?

Aside from looking at companies that pay dividends on time, you should also look to see if dividends have been growing over time. A company that can afford to increase its dividend payout is a signal that it is growing and is doing well. This also shows stability in the company. Don’t believe what anyone says about dividend investing being boring, if a company has consistently growing its dividends, then more likely than not, that company is well managed and financially solid. As a company gets richer, dividends get paid, and the stock price appreciates as a result of increased earnings, higher profits, and better management. So dividend growth also indicates that the business is running well and long term growth.

Here is an example of the top ten dividend paying companies of all time. These companies have consistently increased its dividends for at least the past 50 years.

 

Company Symbol Since Last Raise
3M Company MMM 1959 7% (February 2012)
American States Water Company AWR 1955 8% (April 2011)
Cincinnati Financial Corporation CINF 1961 <1% (August 2011)
Diebold Incorporated DBD 1954 2% (February 2012)
Dover Corporation DOV 1956 15% (August 2011)
Emerson Electric Co. EMR 1957 16% (November 2011)
Genuine Parts Company GPC 1957 10% (February 2012)
Proctor & Gamble PG 1957 7% (April 2012)
Northwest Natural Gas NWN 1956 15% (August 2011)
Vectren Co. VVC 1960 3% (November 2011)

Looking at this chart, you can see that many of these companies are household names. Even in a recession, people will still need scotch tap, shampoo, or soap right? Too bad you didn’t have this list back in 1957. A $10,000 investment in P&G would have grown to more than $4,000,000 today.

 

The great thing about dividend investing is compounding returns. Instead of spending the dividend income, if you were to reinvest these dividends back and purchase additional shares, you can profit more from the appreciation of the stock. For example, say you choose a defensive stock that has stable (and growing) sales and has a long history of paying off dividends. If the company gives a 3% dividend yield and has appreciated 7% for the year, Your overall return would be more than 10% assuming you reinvested those dividends.

So what should you look for when looking at companies to invest?

1. Defensive Companies

You want to choose a company with a long-term investing strategy. These companies should sell products that are in demand and are stable despite the economy.  Your intention should be to never sell as selling kills that income stream.

2. The Financials
A companies income is driven by earnings. Look at the past 2 years of earnings or Revenue-Cogs = Earnings, or a better measure is EBITDA, earnings before interest taxes depreciation and amortization. Is EBITDA growing or shrinking? Other things to consider is its balance sheet and statement of cash flow. To read more in detail about evaluating a stock’s financials read this article: How To Invest Like Warren Buffett 

3. Economic Moat
Basically how hard is it to enter the business? A company can make lots of money selling a hot product today, but in 10 years, other competitors can decrease profits and may drive that company out of business. Companies that have a sustainable advantage will produce higher returns on their investment than other companies, and will stay in business long term. The four types of economic moats are Intangible assets, customer switching costs, the network effect, and cost advantages. Companies with such economic moats include Disney, Walmart, Microsoft, Johnshon & Johnshon, and McDonalds. These companies have been around for decades and benefited from above average returns as a result of their competitive advantage.

4. Dividend Payout History
I have mentioned this before, but it is worth a re-mention, look for a company with a long history of paying dividends and also that their dividends are increasing like clockwork. This move signals to investors that the management is investor-friendly and will imply that in the future, dividends will consistently be paid and increased further.

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