In this article, we discuss 10 things every dividend investor should know. If you want to read more about dividend investing, go directly to have a look at 25 Things Every Dividend Investor Should Know.
10. Dividend Reinvestment Plans (DRIPs):
Dividend reinvestment plans, or DRIPs, allow investors to automatically reinvest dividends into additional shares of the company’s stock. Through this strategy, investors are able to compound their investment over time without experiencing transaction costs. In addition to this, investors can gain long-term benefits from their dividend investments as dividends are automatically reinvested without any additional action from the investor.
A report by Wisdom Tree illustrated the remarkable power of compounding, where reinvesting dividends increased wealth accumulation over time, along with playing a significant role in the market’s overall returns. The report mentioned that dividends and reinvested dividends have accounted for 69% of the market’s returns since 1978. This means that if someone had made an investment of $10,000 in the stock market in 1978 and consistently reinvested their dividends, their investment would have grown to over $1.6 million in 2023.
9. Dividend-Paying Companies Tend to Have Higher Earnings Growth:
The connection between dividend payments and earnings growth depends on various factors, such as financial health, company size, the industry, and its commitment to shareholders. As we have previously discussed, companies with strong cash flow generation tend to raise their dividends regularly and also reinvest the cash into other projects like research and development and expanding their operations. This may increase their earnings over time. This means that the correlation between dividend companies, earnings growth, and cash generation intertwines with each other. This can be seen from the performance of dividend-paying companies in 2023. Though dividend stocks lagged last year, corporate global dividends reached a record high of $1.66 trillion, up from $1.57 trillion paid in 2022.
8. Dividend Stocks Can Generate Higher Returns Than Bonds:
Dividend stocks, offering the potential for both capital appreciation and dividend income, have the ability to generate higher returns than bonds. On the other hand, bonds offer limited opportunities for price appreciation. In addition to this, bond yields can also be temporary. Short-term Treasury bonds with a one-year maturity offer the highest yields, exceeding 5%, while long-term bonds offer lower yields due to an inverted yield curve. In comparison, dividend stocks can sustain their yields for many years.
According to a report by Barron’s, investors seeking income are particularly drawn toward yields. So, when the interest rates were nearly zero at the beginning of 2022, dividend stocks held up better than bonds, as bonds typically move in the opposite direction of interest rates.
7. Dividend Stocks Can Provide Downside Protection During Market Downturns:
Though dividend stocks are still subject to volatility, they can still offer some protection during market downturns. According to a report by Morningstar, dividend stocks performed well during economic slowdowns that occurred in July 1981, March 2001, and December 2007. The report also highlighted the outperformance of dividend growth strategies in inflationary periods. Dividend growth stocks delivered an annual average return of 9.93% over the trailing five years through July 2022, outperforming income strategies, which returned 7.56%.
In addition to dividend growth stocks, high-dividend stocks have also shown a stable performance during times of market instability. Capital Group cited data from Eugene Fama and Kenneth French and revealed that these equities have a more favorable 30-year downside capture ratio of 76%, compared to 124% for non-dividend stocks.
6. Dividend Stocks Are Less Sensitive to Changes in Business Cycle:
Companies that pay regular dividends to shareholders have more stable business models, strong cash flow generation, and mature operations, which help them stay afloat during economic downturns. Moreover, dividend-paying sectors, such as utilities, consumer staples, and healthcare tend to be less cyclical and more resilient during economic clampdowns. However, dividend stocks can also be volatile, which mainly depends on the market conditions and industry dynamics.
5. Dividend Stocks are a Valuable Source of Income for Investors:
Income generation is one of the top priorities of investors when considering dividend investment strategies. In our article, 15 Best Income Stocks to Invest In, we have highlighted the income aspect of dividend stocks, revealing how dividends have played a significant role in boosting personal income over the years. The report referred to data from S&P Dow Jones Indices, mentioning that dividends made up 8.5% of personal income by the end of 2022, growing from 3.2% in the first quarter of 1980.
4. Preferred and Special Dividends:
Preferred dividends are paid on preferred stocks. These dividends are considered more important than common stock dividends and are calculated based on the par value of the preferred stock. These dividends are generally paid out quarterly, providing investors with a steady income stream.
On the other hand, a special dividend is a one-time supplemental dividend that is mainly paid when the company has excess cash and wants to share profits with shareholders. To learn more about special dividends, have a look at our article, 11 Stocks that Paid Special Dividends in 2024.
3. Tax Benefits of Dividends:
Though tax treatment of dividends largely depends on individual circumstances and tax laws, dividends can offer certain tax benefits to investors. Qualified dividends, which are paid by US corporations and certain foreign companies, are taxed at the long-term capital gains tax rates. This tax is generally lower than the income tax and depends on the individual’s income level and filing status. On the other hand, nonqualified dividends are taxed at the same rate as ordinary income. Moreover, dividend stocks can offer tax advantages when held within retirement accounts such as individual retirement accounts (IRAs) and 401(k) plans.
2. Investors Should Pay Attention to Company Fundamentals:
Companies with strong fundamentals are more likely to maintain and grow their dividends regularly. Before making an investment in dividend stocks, analysts advise investors to meticulously analyze the respective company’s balance sheet and its earnings trend. A large number of companies slashed or stopped paying dividends during the pandemic of 2020, exposing their financial instability. At the same time, many companies maintained and even increased their payouts during that period, which indicated strong fundamentals and robust financial footing. Steve Greiner, vice president of Schwab Equity Ratings, spoke about this aspect in one of the firm’s reports. He said:
“Fortunately, companies generally only cut dividends when they’re in distress, so favoring those with sound financial metrics can help mitigate this risk.”
1. Dividend Coverage:
Dividend coverage is a measure that highlights the company’s ability to support its dividend payments through its earnings or cash flows. A higher dividend coverage ratio shows that the company has ample cash to fulfill its dividend payments, while a lower ratio suggests that the company’s dividends are less sustainable and it may be at risk of reducing and suspending its dividends.
You can also take a look at 13 High Growth Value Stocks to Invest in According to Seth Klarman and 15 Best 5G Stocks To Buy According to Hedge Funds
