7 Golden Rules of Dividend Investing - New Academy of Finance (2024)

Getting passive dividend income every month is a dream come true for many, particularly if that income more than offsets one’s expenses. It is like achieving the “Holy Grail” of dividend investing. All of us talks and dream about it but alas, few ever seem to accomplish it.

Dividend Investing: The Yield

When it comes to dividend investing returns, there are two key components: 1) Returns from dividends and 2) Returns from price appreciation. The importance of dividend return often gets ignored because price appreciation garners much more attention during bull market periods. However, over a longer-term horizon, dividends account for a stable and significant part of the equity premium. Going back to 1960, 82% of the total return of the S&P500 Index can be attributed to reinvested dividends and the power of compounding.

As we are coming towards the tail-end of the business-cycle with a recession now a potential concern among many developed nations, returns from capital appreciation will likely play second fiddle to that of dividend returns. Dividend investing will likely see increasing importance.

Dividend Investing: The Safety

Consistency in dividend payments or what we termed as dividend safety is essential to the success of a dividend investing strategy. Chasing the highest yielding stock is often a key investment fallacy undertaken by newbie dividend investors. Sustainability of dividend payments should be given higher priority because companies that pay out a significant share of their earnings in dividends might 1) not be able to sustain such a dividend trend which implies that future dividend payment might fall or 2) they are not reinvesting back into their business to further grow the top-line.

When it comes to dividend safety, strong balance sheets and robust underlying economics of the business, coupled with low or moderate pay-out ratio are key indicators crucial in dividend investing.

Dividend Investing: The Growth

While dividends are an important component of a counter’s total returns, it has been proven that companies that consistently grow their dividend payments have outperformed dividend payers lacking dividend growth by as much as 34%, according to studies done by research firm Ned Davis. The combination of a high dividend yields today and even higher dividend payments tomorrow can serve as a potent tonic for one’s dividend investing portfolio.

Putting the pieces together to complete the puzzle

A quality dividend investing strategy will consider each factor that influences the performance of dividend-paying companies.

We develop the following tried-and-tested rules for dividend investing. We have broken down the most important practices that all dividend investors should know and follow and narrowed down to a list of 7 rules designed to help you navigate and overcome the pitfalls of dividend investing.

Dividend Investing Golden Rule #1 – Growth Rule: Invest in stocks with track records of dividend growth

Quality beats Quantity. You want to be invested in stocks thatnot only spot a higher-than-average yield but one that has shown consistency inincreasing their annual dividend payments. Before investing in anydividend-paying stock, be sure to check its dividend history first. Make surethe company has not cut its dividend payment recently. Another shortfall is stagnantdividend payments, one where the company has not increased its dividendpayments for a long-time.

In general, dividend investors should look for dividend stocks with a dividend CAGR of 3% over the past 5 years.

Dividend Investing Golden Rule #2 – Bargain Rule: Invest in stocks with a higher-than-average yield to maximize cash flow from your investments

Everyone loves a good bargain. If a stock passes Rule #1,which is an up-trending dividend payment profile, then one should look atchoosing a counter with higher-than-average dividend yield payment. The currentyield of the STI Index is approx. 3.7% while that of the S&P500 is approx. 2.0%.

As a simple rule of thumb, we will classify a stock with a yield in excess of 4% as one that is high-yielding in nature. High yielding dividend stocks have typically outperformed lower-yielding dividend stocks and non-dividend payers as well as dividend cutters by significant amounts, as illustrated in the table below, based on data from Ned Davis Research and Hartford Funds, illustrating the performances from 1972-2018.

The best performers, however, have been dividend growers, thatis why they sit atop as our Rule #1.

A word of caution. Do not simply go for the highest yielding stocks (more on that in Rule #3). These stocks might be paying out too much in dividends and retaining too little to grow their business.

Dividend Investing Golden Rule #3 – Dividend-Trap Rule: Invest in stocks that do not have high pay-out ratios

Simply chasing after high yield counters that cannot sustain their dividend payments is a common dividend investing mistake that rookie investors make. Such stocks are Dividend traps, meaning that their high yield is nothing more than temporary bait to lure investors seeking high yield. However, that high-yield is often an illusion, one that is not sustainable.

One simple way of checking of a dividend payment is sustainableis by looking at the counter’s payout ratio. This refers to the percentage ofits net income the company pays out in dividends. If a company earned $5/shareand paid out $3/share in dividends, it would have a Payout Ratio of 60%.

A Payout Ratio below 60% is typically within an acceptablerange for a mature business that does not have to reinvest a large chunk of itsearnings back for growth.

A Payout Ratio of 75% or higher could be difficult tosustain if a company experiences a prolonged drop in earnings

There are however some exceptions to this rule. For example, REITs typically have Payout ratios in excess of 90%. Another example is when the economy is in a deep recession, a company’s earnings might be temporarily hit, which pushes their Payout ratio unusually high. As long as the company has a strong cash buffer with no structural impact to its core business profile, then it should not have too much problem maintaining its current dividend payment.

Dividend Investing Golden Rule #4 – Sustainability Rule: Invest in stocks that are showing an uptrend in revenue growth

It is not sustainable for a counter to have a growingdividend payment profile but yet demonstrate sustained weakness in its corebusiness revenue. A company’s operational growth is what drives its ability topay higher dividends. Revenue growth is often the very first requisite towards generatingsustained higher earnings and consequently the ability to pay more dividends.

While a company’s cost-cutting efforts can lead to an improvementin its bottom-line, there is limited scope for cost-cutting initiatives tocontinuously drive earnings improvement without a corresponding rise inrevenue.

One point to note. Competition among companies has intensifieddue to globalization and the rapid pace of innovation. Even a blue-chip todaywith a fantastic track record of consistent revenue, earnings and dividendgrowth might cease to be relevant in a changing structural environment.

It’s no longer enough to just buy a blue-chip dividend payer and not look at it for the next 30 years and assume that everything will work out fine. Having alaissez-faire approach might work in the past but could be a recipe for disaster in today’s rapidly changing landscape.

Dividend Investing Golden Rule #5 – Cash is King Rule: Invest in dividend stocks that are generating consistent cash flow

The best dividend stocks are often those that demonstrate the ability to generate consistent cash flow. It is the actual cash that is used for dividend payments, not just the fact that a company is generating higher revenue or earnings. Higher revenue or earnings generation that is not accompanied by a corresponding increase in cash flow over time is a potential red flag and a clear signal that dividend growth is not sustainable.

Also, look out for companies that might have huge capital expenditure requirements ahead which might stifle their ability to pay higher dividends.

Dividend Investing Golden Rule #6 – Sleep-tight Rule: Invest in dividend stocks that are not overly volatile

Stocks with lower volatility have a history of outperforming higher volatility stocks in all business cycles. Dividend stocks by nature tend to exhibit lower volatility.

Their businesses are more mature and stable vs. growthstocks (non-dividend payers) and hence lower the probability of “negative/positiveearnings surprises” that tends to escalate their stock price volatility. Thisruns counter to the prevailing belief in investing that higher risks aregenerally rewarded with higher returns.

However, this is not a one-rule fit all scenario. There are still many high dividend stocks with high volatility aka high risk. Since risk is not rewarded, one should be selective and focus on low-risk stocks that also exhibit high and stable dividends.

Dividend Investing Golden Rule #7 – Time-to-sell Rule: Develop a sell strategy and stick to it. Cutting of dividend could be seen as a major red flag

Most investors focus on buying and neglect the selling. Thisrule is quite possibly the most important one of all. Dividend investors alwaysneed to keep in mind that engaging a “Buy and Hold” strategy does not mean “Buyand Hold and Forget, regardless of how far the stock has fallen”, many timesreasonably so.

Dividend investors should also develop a sell strategy in orderto protect profits and minimize losses. It is time to sell when a stock isoverpriced, using certain metrics like Price/Earnings ratio or when a stock hasfallen significantly below your entry level (-15% could be the initialthreshold). In the latter’s case, we suggest taking a close look at the company’sstatistics to assure yourself that its fundamentals have not witnessed astructural change for the worse.

Sometimes, a drop of 15 or 20% could just be the effect of market gyration and not company-specific. Usually, however, such a drop, particularly in a short period of time, could indicate company-specific problems that warrant further investigation.

Conclusion

The 7 dividend investing rules we have outlined in this article are a good foundation upon which to develop a solid dividend investing strategy. These are by no means complete nor are they hard and fast rules but a useful guide for dividend investors to keep in mind when building their dividend portfolio. Investors often focus on short-term price fluctuations. However, there is plenty of evidence to illustrate that focusing on long-term dividend plays do “PAY DIVIDENDS” at the end of the day.

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Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only.