Dividend stocks are an essential tool in building long-term wealth. Yes, buying low and selling high gets the heart going, and makes for great stories to share with your buddies, but it is often accompanied by its less welcome cousin, buying high and selling low, or the family weirdo, buying low and staying low, wasting years, and eating up fees and opportunity cost in the meantime. Dividend stocks make good returns better, bad ones less bad, and ensure your money is always working (i.e. providing a return) even if the stock itself is flat.
What are dividend stocks?
Dividend stocks are stocks that regularly send money to their investors. Simply put, dividends are a share of profits that companies distribute to their owners after expenses have been paid. When a company is young and growing, the profits are usually reinvested into the company, in hopes that the reinvestment will lead to a virtuous circle of continued growth. After a time, companies grow to maturity, and growth is no longer the company’s prime concern. To be sure, (most) companies will always strive to grow, and even the largest companies are able to continue to do so, but a lower percentage of the company’s income is needed to achieve this growth. This frees up money to be used differently. Companies can find a variety of ways to spend this money, and one of the most popular ways, as far as shareholders are concerned, is to have the money sent to them in the form of dividends.
All the stories we’ve heard about the Canadian banks recording record profits quarter after quarter for much of the past two decades in particular are a good example of companies achieving growth in both stock price and dividends. Obviously, for record profits to become the norm, the banks have been growing their businesses. Yet, at the same time, the banks have paid regular — and often increasing — dividends to their shareholders. The Bank of Montreal, Canada’s oldest bank, has been paying uninterrupted dividends since 1829. With certain stocks, Canadian banks being one of them, you can pretty-much count on the dividends being reliable and growing over time. This notwithstanding, investors must realize that dividend payments are not a contractual obligation, and that dividends can be reduced or even eliminated if the company’s Board of Directors feels it necessary. This may occur due to, for example, difficult economic times, or the stockpiling of money for a major acquisition.
How are dividends stocks beneficial?
- Dividends can’t be faked. Not to sound paranoid or anything , but companies can and do manipulate their accounting to advantage. Think Enron. They were able to fool people with far more expertise and experience than I will ever have in reading a balance sheet by using what I’ll call “freestyle accounting”. Dividends require real money to be used — so they are proof that the company actually has the money they say they do.
- If you buy high and the stock goes down, dividends can bail you out. Obviously, buying a stock that decreases in value is no fun, but it happens to every investor sooner or later. Barring the company actually going under or the elimination of dividends, these monthly or quarterly payments will eventually repay the money you have lost in stock deprecation. It is not too hard to think of a stock where dividends did not save the day, such as Nortel, but the fact remains that they are an extra level of security. I will be detailing how dividends bailed me out of a bad situation in an upcoming post.
- Very favourable tax rates. If you like paying taxes, dividend income is a lousy choice. On the other hand, if you look forward to paying taxes with about as much enthusiasm as plucking nose hairs, then you should know that dividends are the lowest-taxed way to earn money in Canada. Also, unlike capital gains tax, where you are taxed only when you sell, you are taxed on your dividend income every year. Personally, I consider this an advantage; I consider it a pay-as-you-go scheme, unlike capital gains tax, where you get walloped with many years of capital appreciation all at once in the year you sell.
- Dividends are generally reliable. There are of course lots of exceptions to this, but generally speaking, companies do their darndest to try to avoid reducing or eliminating their dividend. Dividends are based on the company’s real earnings, not how popular their stock is or isn’t at a particular moment. While the reliability of dividends is far from 100%, it is much higher than the manic swings in the stock market that traders are subject to.
- Dividends generally go up. Again, there are lots of exceptions, but if a company is doing well, it will usually try to raise its dividend annually. The list of companies that can do this decade after decade is rather short, but there are companies that manage to do so. The longest active streak in this regard in Canada is Fortis Inc., (FTS) which has raised its dividend in each of the past 40 years. While increased dividends are of course good in and of themselves, there is an additional benefit: when companies raise their dividend, stock price tends to follow. There are a few reasons for this: Firstly, it is a sure sign that management (who knows the company better than anyone) has confidence that the company is on the right path, and will continue to increase its earnings. Secondly, people like me, who look buy stocks for their dividends, see that the dividend has increased, and demand for the stock increases. The result is a higher stock price. Conveniently, there is a name for companies that raise their dividends year after year: Dividend Aristocrats. Even more conveniently, here is an often-updated link to Canadian Dividend Aristocrats.
- Dividends provide a consistent source of new money. The money that investors collect is “new” money; money that the investor didn’t have before. This new money can be re-invested into more dividend stocks, thereby increasing the amount of future dividends collected, and in turn creating an ever-increasing source of income. Also, if necessary, dividend payments can be used to get through lean financial times. Once the amount of dividends coming in is sufficient to cover monthly expenses, an investor can consider himself financially independent. Doing the math on your monthly dividend income vs. your monthly expenses can give you a very good idea of when you’ll be able to retire.
A portfolio of properly chosen and diversified dividend stocks can provide an investor with a constant, inflation-adjusted stream of income that is taxed very favourably. Dividend investing isn’t as sexy as tripling your money in six months like some traders are able to do on occasion, but it is predictable and reliable, and as far as I’m concerned, there are places in life far better than my investments to find thrills.