How to Invest in Dividend Stocks: Only 3 principles you need to know

I have occasionally given advice to people who want to invest so that they can get steady revenue from the dividends paid by the company. In this article I want to clarify that an investor who decides to invest solely with the aim of obtaining dividend income can be successful provided that they don’t make matters too complicated for themselves and that they adhere to simple but important logic. So lets cover those only 4 things you need to know for investing into dividends!

As I have written in previous articles, investing requires self-control and a watertight strategy. However, building up a strategy and self-control is not an end in itself. Investing involves all kinds of disciplines; business and the future in general are indeterminable by nature and there is fierce competition to achieve yield on the stock market – so strategy and self-control are nothing more than means for remaining focused in this big, confusing world. They serve the aim of avoiding speculation and gambling (or in other words, the risk of losing money).

It ought to be explained to beginners that value investing and growth investing have been the most productive investment strategies of all time. But during their first steps, a beginner will not understand much about these investment principles. There isn’t one particular piece of advice on how to invest successfully in one way or another. This is also why beginners are told that the most important thing is to learn, learn and learn some more. And constantly read. This maintains the hope that if a beginner is persistent enough, they will eventually experience moments of sudden realization and through this learn from their own mistakes and those of others.

Investing in dividends can be one of the easiest ways of starting to invest successfully.

What motivated me to write this article was in fact investing trainers with limited market experience whose numbers keep increasing and who teach people in the wrong way.

Beginners interested in investing are hit with a confusing overload of information that it is very difficult for the investor to set their focus. If someone goes to an investment training event knowing they want to invest in companies that pay dividends, I’m more than certain that they’ll gain almost nothing from the average event. But investing in dividends is not a science: it can be easily handled without any information overload. And it’s one of the most popular ways to make money grow.

PART 1. Investing in stocks of companies that pay dividends

Let’s start at the beginning. Companies pay dividends (part of the profit being distributed between shareholders) for very different reasons. Let’s list a few common ones:

  1. The core owners personally lack money.
  2. The company has no use for the money itself – this is generally an odd reason, but many big global monopolies really don’t have anything to do with the money anymore, which is why a large part of the money earned is paid out to the owners. Coca-Cola is an example of this;
  3. The aim is to gain the interest of investors and, through this, inflate the prices of stocks. It is common for problematic companies to increase the sums paid out when the company starts performing worse and the price of the stock is under pressure. Overall, this is a rather short-sighted approach that shouldn’t be used.

However, companies occasionally stop paying dividends as well and the reasons for this are quite different. For example:

  1. The company is performing badly for some reason – companies often try to continue paying dividends when problems arise. It may be the significant decrease of sales or even a lawsuit. Nevertheless, if this is not done, investors lose interest and the stock price may fall significantly. Thus, at times, some companies even attempt to pay dividends with the help of credit, which during bad times is like hanging a powder keg over a fire. If the problems continue, then in the end spare money runs out and the banks don’t issue any more loans either. Therefore, the payment of dividends is terminated altogether.
  2. The company needs money for investments – usually for expansion e.g. for acquiring another company, or construction for new facility, purchasing new ship for shipping company etc. This may lead to a temporary suspension or cut of the payment of dividends.
  3. A change of strategy e.g. after a merger – when the company’s circle of owners is mixed up, the company’s strategy may also change: the focus may shift from making a profit to growth or something similar.

In short, the payment and non-payment of dividends is affected by many different decisions made in the company. There are many reasons and incentives and it isn’t my aim to highlight each of them here. From the examples above, I instead want to derive the most important principle for a dividend investor to keep in mind. In the meantime, however, let’s talk about the investor themselves.

PART 2. An investor’s expectations of yield

We all want the money we set aside as savings to grow. In a world where interest rates are negative, growing money safely is very complicated. The banks only pay around 2% for a one-year fixed-term deposit. The historical stock market average is somewhere around 11-12%. And this means a buy-and-keep strategy – in other words, buying a stock of a company and keeping it for 100 years, for example. Real estate rental yield is somewhere around 8%. As interest rates have decreased, so have the yields of bonds and bonds with AAA credit rating are also trading at around 3-4%. In crowdfunding, the yield has ranged from 8%-15%, which is quite good considering the risks. As a side note, it should be said that this is why crowdfunding is so popular these days.

How should an investor decide? Yes, we all want our money to grow as fast as possible. If it did, we could invest all of our money in stocks in the hope that the stock prices would rise – as history has shown. Well, this can be done, for example by buying index funds, which are essentially groups of stocks. But let’s face it, selecting good, productive stocks and funds is a very difficult task for a beginner. And crowdfunding seems like a raw, risky and unregulated field, as money is essentially entrusted to the care of one group of people who manage the crowdfunding platform. Often, the choice between projects may be rather superficial due to a lack of time, which makes the investment more speculative and thus also increases the risk of losing money.

Well, let’s leave the top part aside and try to limit ourselves to safer choices.

Let’s say you’d be fine with a yield of around 6% and that you wouldn’t want to commit too much of your time to investing. So investing in bonds or in companies that pay dividends should suit such a person very well.

The bonds and dividends referred to in the last sentence fit very well into the context of this article as well.

Investing in bonds and dividends is very similar in principle. In both cases we anticipate a regular payment. In the case of bonds, we have issued a loan and await an interest payment from the borrower. When we have bought a stock of a company paying dividends, we await a regular payment of dividends to our account.

The statement above is fundamentally very important!

Now, those who have read my articles more thoroughly may notice that I contradict my own investing principles a bit in what follows. But let it be said that I’m not exactly a dividend investor. At least when it comes to choosing a company, dividend yield is not my criterion.

If investing is done with the aim of gaining dividend revenue from the companies in the portfolio, the worth of the company’s stock at a certain point in time is irrelevant. Actually, certain principles that are important in value investing or growth investing do not matter at all.

For a dividend investor, the most important thing is that the company pays dividends!

So lets repeat. For a dividend investor, the most important thing is that the company continues to pay dividends. Although debt and the interest earned from it on the one hand and the revenue earned by a company and paying part of it to shareholders on the other are very different things, they are easy to compare as far as the investor’s expectations are concerned.

But they are also competing, as the question arises whether to invest in the bonds of a well-performing company (lend money to the company) or to be a shareholder and earn dividends. Other factors play a role here, however, and I will not dwell on this dilemma; I will stick to the question of whether a company will continue paying dividends after an investment is made.

SIMPLE EXAMPLE:

I will give a simple example of expectations of yield. Let’s say that a company is admitted to a stock exchange listing, one stock of which can be bought for 100 euros and the investor wants to gain 6 euros in dividends per year (i.e. dividend revenue of 6% per annum). The investor buys this stock today and in this context it is completely irrelevant whether this stock will cost 75 euros or 125 euros tomorrow. For the investor, it is important that the company continues paying dividends of at least 6 euros so that they can obtain their annual yield of 6%.

If, however, the company is reducing its dividends, this is an important event for the dividend investor and it can be concluded that the investment has partially failed.

For example, the company is halving its dividends, to 3 euros. Alright, the dividends remain, but the yield of the investment is now 3% per annum. This is not alright, and as investors still expect a yield of 6%, their interest in the stock decreases. In theory, it decreases until the yield level of 6% is attained again. Which means that the price of the stock falls to 50 euros.

To put it simply, the same maths also apply in the bond market. In reality, of course, there aren’t such clear connections between the prices of stocks and dividends. On the bond market, some of the biggest variables are the risk-free interest rate and the level of market rates.

But in order to refrain from complicating things too much, let’s conclude with the following.

PART 3. How to invest into dividend stocks?

As the only important thing for the dividend investor is that the company pays dividends, when purchasing stocks the investor should make sure following 3 things:

  1. they by the stock at a price that corresponds to their yield expectations;
  2. the company is able to pay dividends (over basically an infinite period);
  3. if the company stop paying dividends or reduces them, they know why.

The latter means that the suspension or cut of the payment of dividends is not necessarily a negative event. When we make a choice between companies, the risk associated with the suspension of the payment of dividends is not the same.

I briefly referred above that there are several reasons why companies suspend or cut dividends. Lets take the company A that is investing into growth and the company B who has pending lawsuit. Both of them are paying regular dividends.

  • If company A starts constructing a new building and is forced to reduce its dividends as the spare money goes into investment activities, this is a positive risk for the investor. Once the building is completed and it guarantees positive cash flow and growth for the company in the future, the dividend is restored or even increased.

Generally such companies are also categorized as growth companies and the investors’ interest grows, which means the stock price also rises. When analyzing growth companies, investors like to play with various ratios, like P/E and earnings growth ratios.

For me, predicting profits is equal to predicting the weather and I don’t place much value on any ratio analyses based on profits and cash flows. That said, I do carry them out for companies in my portfolio as well. But what we’re talking about is investing in dividends, not growth investors.

  • As another example, I pointed out the company B. The company will be forced to cut down on dividends if it has to reduce its revenues due to a negative court decision.

There are lot of interesting and even ridiculous stories about the lawsuits against big businesses. Find them here…

Lets call this dilemma a choice of positive risk and a negative risk. If an investor is faced with a dilemma of whether to invest in the stock of A or B, then according to the brief analysis above, A is clearly the wiser choice.

3 simple dividend investing principles the investor needs to follow:

  1. to buy stocks of a company paying dividends only at a price that corresponds to the investor’s yield expectations;
  2. to identify factors that will affect the ability of the company to pay dividends in the future; and
  3. to consider what will happen if the risk that the company will stop paying dividends is realized (whether this is a negative or positive event) and to prefer companies for which this is a positive risk.

As you can see, we didn’t talk about any sorts of ratio analyses, nor stock prices or their prediction, nor whether the market is a bull market or a bear market. And the reason I didn’t talk about these vague things is that when it comes to investing, they often don’t need to be talked about! That is what the principle of investing in dividends is all about. The rest is just refining the details!