Embracing Dividend Value Investing
David J. Waldron
Contributing editor and author of Quality Value Investing | Helping readers achieve their career and financial goals since 2013 | Join 1200+ Subscribers of the QVI Newsletter on LinkedIn and Substack
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Welcome to the eleventh segment of the serialization of my next book, Quality Value Investing: How to Pick the Winning Stocks of Enduring Enterprises (working title and subtitle). I am writing the book on LinkedIn as part of the QVI Newsletter and look forward to subscribers’ support and feedback as we produce the manuscript in real time.
Book Segment #11 uncovers?an alternative yield methodology for outperforming Treasury rates without the limitations of the dividend growth strategy—such as overweighting dividend history—or the inherent risks of high-yield dividend investing.
Dividend investing is buying securities that pay dividends to receive a regular income from our investments. The dividend income is in addition to any capital gains in our portfolios as the constituent common stocks, exchange-traded funds, or other holdings increase or decrease in value.
Dividend growth investing is a popular strategy with retail investors. It entails buying shares in companies with a record of paying regular and increasing dividends, commonly referred to as kings and aristocrats in the financial media. An added component is using the payouts to reinvest in the company’s shares—or shares of other companies with similar dividend track records.
Dividend value investing focuses more on the company’s quality and the stock’s value than its dividend growth history. In other words, any dividends are a bonus payment in the short term while waiting for capital gains to compound over the long term.
QVI advocates dividend value investing toward preserving invested capital in contrast to dividend growth and high-yield investing.
Principles of Dividend Value Investing
The quality value investing model of owning the common shares of world-class enterprises purchased at reasonable prices builds winning portfolios over time from the compounding total return of capital gains and dividends, the two best financial friends of everyday retail stock investors.
Any ongoing dividend yields are the stock market equivalent of receiving interest payments on the outstanding principal of a loan or the equivalent of the initial capital investment to purchase the shares of the stock.
The pursuit of alpha equates to a portfolio of predominantly dividend-paying common stocks of quality companies outperforming the corresponding benchmark over time, plus exceeding any other expectations of disciplined long-view investors.
Owning US exchange-traded common shares representing companies paying reasonable dividends far outweighs the risks of perceived fast money opportunities from non-dividend momentum growth stocks or high-yield dividend payers. Thus, consider keeping major exchange-traded, quality, non-dividend-paying growth stock allocation to a minimum. Quality dividend value stocks compensate us now with regular payouts and reward us later with compounding capital gains.
Target companies with a forward dividend yield or the annual dividend rate divided by the current stock price exceeding 2 percent and below 6 percent. However, consider buying the dividend-paying stock of a quality company trading at an attractive price if the historical yield is below 2 percent. Trailing dividend yield indicates how much a company paid out in dividends for the previous twelve months relative to the share price. The dividend rate is the dollar sum of dividends paid over the prior fiscal year.
Most high-yield and some dividend growth investors gravitate to dividend yields far exceeding the Ten-Year Treasury rate. On the contrary, disciplined investors are cautious with dividends susceptible to erratic stock price fluctuations, unexpected rate decreases, or unsustainable payout ratios.
The dividend payout from an expensive stock equates to a dividend purchased or held at a high cost. Value and price prevail in every area of investing. Thus, consider practicing the more balanced approach of value-based buy-and-hold total-return investing.
With 41 of the 45 companies currently paying a dividend, the Quality Value Investing?Real-Time Stock Picks, on the whole, seek long-term compounding growth of both principal and income. Achieving a sufficient current income from regular dividends is paramount to the total return objective. Therefore, with occasional exceptions, a company should pay a standard premium for the common shares to be eligible for QVI coverage.
Chasing Yield is a Recipe for Junk Equity
Chasing dividend yields and non-dividend momentum growth from equities are recipes for junk. Instead, build wealth with total-return investing—capital gains plus income—and, in retirement, pursue bucket list items instead of desperately seeking higher dividend payouts.
Quality-driven value investing focuses on dividend yields below 6 percent, a range where we find superior companies paying far lower than 100 percent of earnings in dividends, also referred to as the payout ratio, addressed further later in this post. Many companies behind 6 to 10 percent and higher-yielding shares must grow dividend rates, or the stocks need to fall in price, or a combination thereof, for the dividend yields to remain high or increase. Those are recipes for destroying invested capital.
High-yield dividend stocks were top-of-mind for investors starving for higher payouts in the low-interest-rate environment of the post-Great Recession bull market. As a result, many top subscription offerings and financial media pieces focused on the high-yield paradigm. Unfortunately, history tells us the crowd is almost always wrong regarding fads and favorites. High-yield dividend stocks are no exception, so rationally-thinking investors should maintain a skeptical view of the practice.
Along with elevated income returns, loom risky headwinds and questionable underlying fundamentals. Just ask the victims of the high-yield junk bond bubble in the 1980s. History also reminds us of how that bubble burst during the 1987 stock market crash. The junk bond craze returned to the recent bull market through high-yield dividend stocks. This time, instead of leveraging mergers and acquisitions at the corporate level when available capital was insufficient, high-yield equities influenced daring risk/reward plays as retail investors and advisors sought outsized returns to leverage underfunded retirement account balances.
An inevitable cyclical downturn in the overall stock market preempts the principal capital invested by millions of retail investors concentrated in risky, high-yield dividend equities such as business development companies [BDCs], master limited partnerships [MLPs], closed-end mutual funds [CEFs], real estate investment trusts [REITs], as well as energy transfer partnerships and preferred stocks.
Disciplined investors never buy stocks based on market euphoria or the dividend yield alone. However, some well-crafted story headlines and marketing pitches cast a positive spin on the paradox of a safe, high-yielder. Unfortunately, such absurdity is akin to fishing for sushi-grade salmon in a crystal clear river known as toxic from a colorless pollutant.
These pundits remind us of what we missed, disregarded, and tripped over in our retail-level analysis, challenging our assumptions and conclusions. Although the professional debate is encouraged and welcomed, the thesis remains that investors are chasing the dividend more than enterprise quality with high-yield stocks. Nonetheless, if a conscientious trading strategy puts income ahead of capital gains, so be it with cautionary best wishes.
Remember, dividend rates adjust monthly, quarterly, or annually from board-directed payouts, as the corresponding yields go up and down each market day as a prisoner of the stock price. The concept of dividend payouts involves a simple paradigm in the fundamental economics of the price/yield relationship, whether bonds or equities. The yield goes down when the price goes up, and vice versa.
The enticement of high-yielding stocks overshadows the necessary due diligence to determine if the representative company is stable enough to justify the yield with capital allocations and shareholder returns from a well-managed operation. For example, do we prefer to own a quality 4 percent yielder with compounding average capital gains of 6 percent a year or a high-risk stock yielding 10 percent, although averaging a minus 5 percent annualized capital loss?
In the former example, value investors average a plus 10 percent annual total gain. In contrast, high-yield fans settled for a meager plus 5 percent average annual total return, barely above the yields of short-duration government bonds.
Of course, some retirees have had the opposite experience by investing in high-yielders that have produced double-digit total returns in recent years.
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An Alternative High-Yield Dividend Model
As an alternative method, measure a stock holding’s yield-on-cost instead of chasing current dividend payouts. The return on cost represents the current annualized dividend rate relative to the cost basis of the common shares. For example, as of the original writing date of this book segment, the yields-on-cost of seven dividend-paying QVI Stock Picks are?superior to the current forward yields.
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Table Key
Yield-on-cost is a far superior investment strategy to conventional high-yield dividend investing and, therefore, is a leading indicator of the QVI Stock Picks.
The All-Encompassing Payout Ratio
The payout ratio is the proportion of earnings paid out as dividends to shareholders, expressed as a percentage.
A lower payout ratio is preferable to a higher one, and a rate higher than 100 percent suggests that the company pays out more in dividends than it earns in net income. Financial laws and regulations require many inflated payout players, such as REITs and BDCs, to distribute at least 90 percent of taxable income to shareholders. Yet, when screening high-yield dividend stocks, more than 50 percent of the companies listed often have payout ratios higher than 100 percent. So, where is the cash flow to support this generosity?
The concern is whether the excess payout is coming from somewhere on the balance sheet or cash flow statement detrimental to the financial stability of the operation. So, instead of chasing risky, high-yield dividends, calculate the yield-on-cost of current holdings with low payout ratios.
In general, avoid initiating a position in stocks with payout ratios or the percentage of net income allocated to dividends exceeding 60 percent. For example, the seven holdings of the QVI Stocks Picks showcased in the yield on-cost table above had current payout ratios of between 16 and 68 percent but were each below 60 percent at initial QVI coverage.
Again, own slices of companies paying sustainable and predictable dividends as those payments will compensate shareholders in the short term. At the same time, wait patiently for the capital appreciation of the stock price over the long term. Own a quality company with a sensible payout ratio, and the dividend yield will likely take care of itself.
Despite the popularity of forward high yields, advocate for the ownership of quality companies represented by dividend-paying common stocks listed on US major exchanges and available at value prices. In retirement, the dividend becomes income in itself. When measured by the yield-on-cost, a low payout ratio dividend rate may earn a high yield worthy of generational ownership.
How Value Investors Allocate Dividends
Most investors prefer reinvesting dividends, whether choosing automatic reinvestment at their broker or using a company-sponsored dividend reinvestment plan [DRIP]. Some investors prefer dollar-cost averaging [DCA] or buying fixed dollar amounts of individual securities regularly. Each method has its benefits.
The hands-free automatic reinvestment plans are appealing and the best path?for passive investors. A traditional advantage of automatic reinvestment at online brokers or using DRIP programs directly from companies was paying zero trade commissions. On the contrary, using dividend cash payments as dry powder entailed potential commissions on future transactions. Nonetheless, the involuntary approach is often more expensive than the direct reinvestment of dry powder.
Whether working on Wall Street or living on Main Street, disciplined, value-driven investors are often suspicious of automatic reinvestment programs. Buying securities at preferred price points and ignoring the whims of the market is the profitable alternative. Allow dividends and capital gains distributions to settle as cash and reinvest the precious dry powder into the equities of quality companies when the prices are attractive.
Buy shares at low prices based on the perception of intrinsic value instead of the market’s offering of the stock price at the moment of the automatic DCA or DRIP purchase. In addition, although the recent trend of online brokers becoming commission-free is good news, investors should continue to build up enough cash, accepting any commission or fees as an insignificant percentage of the gross amount on the trade. Either way, there is no excuse to overpay when reinvesting in the common shares of a company held in our portfolios.
Instead, follow the approach from the value investor playbook of buying equities on our terms instead of allowing the market to determine the entry price, for better or worse. First, have our online broker deposit dividend payments to an insured or government-protected cash account. Then, tap into this accumulation of protected dry powder to purchase new or add to existing investments at bargain prices according to sound valuation analysis.
Ultimately, the choice lies with the investor based on comfort zones, as DRIP and DCA programs also provide a disciplined—albeit rigid—approach to personal investing. Of course, retirees often take dividends as cash to provide supplemental income.
Build Wealth from Dividend Value Investing
High-yield dividend stocks and dividend growth investing were all the rage in the post-Great Recession bull market. However, rational, disciplined, and patient investors are steadfast in dividend value investing or total return from capital gains and dividend income.
A profitable alternative to high-yield investing is calculating the yield-on-cost of quality companies with low payout ratios already residing in our portfolios. Instead of chasing yield, buy reasonably-priced quality and hold for as long as possible, perhaps forever. Any dividend payouts are a bonus.
Despite the noise, remain patient and monitor the enterprise’s prospects while collecting dividends as a short-term reward for our perseverance in awaiting capital appreciation in the long term.
Although safer than high-yield dividend or non-dividend growth investing, dividend value investing still carries the risks of investing in the stock market. For example, all dividend stocks face unexpected rate reductions or suspensions by the company’s board of directors. Nevertheless, the dividend-paying common shares of quality companies tend to be less vulnerable to ticker price volatility and market liquidity than high-yield dividend or non-dividend growth stocks.
Rational, patient, and disciplined quality-driven value investors allow dividends and capital gains distributions to settle as cash and reinvest those funds only when prices are attractive. Arguably, the automatic reinvestment of dividends is convenient, if never the best approach to allocation. Therefore, value-driven investors should consider having their broker pay dividends to cash.
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About the Author
David J. Waldron is the founder and contributing editor of Quality Value Investing and author of the international-selling book Build Wealth with Common Stocks. David’s mission is to inspire the achievement of his readers’ financial goals and dreams. He previously enjoyed a 25-year career as a post-secondary education administrator. David received a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed?The Practice of Management Program?at Brown University.
Disclosure: I/we have long, beneficial positions in the common shares of KO, MSFT, and UNP in our family portfolio. I wrote this book segment myself, and it expresses my own opinions. I am not receiving compensation for it other than from Substack paid subscriptions. I have no business relationship with any company whose stock is mentioned in this post,
Additional Disclosure: David J. Waldron’s Quality Value Investing book segments, newsletter posts, research reports, and real-time stock picks are for informational purposes only. The accuracy of the data cannot be guaranteed. Narrative and analytics are impersonal, i.e., not tailored to individual needs nor intended for portfolio construction beyond his family portfolio, which is presented solely for educational purposes. David is an individual investor and author, not an investment adviser. Readers should always engage in their own research or due diligence and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or specialized attorney before making any investment, income tax, or estate planning decisions.
Copyright 2024 by David J. Waldron. All rights reserved worldwide.