The Ten Commandments of Dividend Investing

In this article, we present the 10 rules that will make you a more successful dividend investor.

One of the most important things to remember about your dividend investments is that you bought each security for a reason. It can be easy for investors to see another security with a higher yield and want to reallocate or feel that their current positions are inadequate. The bottom line to dividend investing is that it’s about more than just the yield. A stock yielding 2% with a solid history and consistent payout is more attractive than a stock yielding 4% with poor earnings management and a fluttering stock price.

A great example is the REIT industry. Many REITs–particularly mortgage REITs (mREITs)–come with massive yields that really catch the eye, but a look under the hood of many can reveal some startling figures like unsustainable payouts, too much debt, or dangerous exposure to rising interest rates. In other cases, a stock may have a high payout because its price has taken a hit, which may be a sign of further trouble to come. Investors will be better off sticking to their fundamentals and allocating to reliable, solid dividend payers.

For an example, we display the returns of some of the most stable dividend payers in the industry versus those with higher yields to illustrate that a higher yield may not always be the best stock pick. The following shows the returns and yields of three relatively stable but perhaps less sexy companies and three high-yielding counterparts; their yields are listed below:

• Coca-Cola (KO ): 2.81%
• McDonald’s (MCD ): 3.53%
• Wal-Mart (WMT ): 2.29%
• Hatteras Financial Corp (HTS): 10.51%
• Annaly Capital (NLY ): 10.53%
• Eagle Rock Energy Partners (EROC): 10.14%

The results clearly display that a higher yield is not always better for you and your investment objectives. You are better off sticking with a reliable dividend from a company with stable, solid financials. If you are having trouble finding the safest dividend plays, sign up for a free trial to access our list of recommended dividend stocks that include some of the most reliable and attractive firms in the marketplace.

The power of reinvesting dividends can often be hard to articulate just using words. Instead, we present a chart that juxtaposes the performance of the Dow Jones Industrial Average versus the Dow Jones Industrial Average Total Return. The latter benchmark assumes all dividends are reinvested. It quickly becomes clear that putting your dividends back to work over time and compounding returns can make quite the difference in your portfolio:

Investors can make use of dividend reinvestment programs, which often allow you to reinvest dividends automatically without paying a commission. As time goes on and more capital is allocated, the dividend payouts can continue to increase, upping the amount of capital invested, and the system loops forward from there. It should be noted that reinvesting dividends does not apply to those who are depending on dividends for income, most often retirees.

The tax structure for dividends has seen a number of overhauls and changes over the years, as lawmakers attempt to develop the most complete and equitable system. The taxes on capital gains, more often than not, will fall below that of standard income taxes. If you recall when Warren Buffett famously stated that he is taxed less than his secretary, part of the reason for that is that a large portion of his income comes from dividends, putting those gains in a lower tax bracket than if they were salary or other compensation.

As it currently stands, here is how qualified dividends are taxed in the U.S.:

Payout ratio is one of the most important stats within the world of dividends. It is used to determine whether or not a company’s current earnings can adequately support the dividend amount. It is calculated by taking the dividend and dividing it by earnings per share as demonstrated below:

Dividend Payout Ratio= Dividend per share (DPS)/ earnings per share (EPS)

A ratio over 100% means a firm is paying out more than it is taking in, typically a red flag when it comes to long-term reliability. While there is no specific “sweet spot” for a payout ratio, anything nearing or eclipsing the 100% mark is often a cause for concern. It is also important for investors to look to forward earnings estimates to properly calculate payout ratios, as many sources use a backward-looking calculation that looks at unadjusted EPS, which leads to an artificially bloated number.

Rather than taking forward year EPS along with the current payout, a number of resources will use the most recent year’s earnings and combine it with current dividend payout, often leading to falsely high figures. Take Verizon Wireless (VZ ) for example. Its most recent fiscal year showed earnings of $2.24, while the forward year is expected to fall at $2.79. Below we display the difference between a backward- and forward-looking payout ratio analysis.

Hold the MLPs, REITs

While payout ratio is a vital stat for most dividend stocks, investors should not apply it to MLPs and REITs. These firms have unique financial structures that require them to return the vast majority of their earnings to investors, meaning they will also have high payout ratios.

The U.S. market may be the largest in the world, but it represents just 50% of the global investing space, leaving plenty of opportunities to invest beyond its borders. When it comes to foreign dividend stocks, there are a few things that investors should keep in mind before making an allocation.

Taxes are the first thing to keep in mind. Some countries withhold taxes well above the standard U.S. rate, while others do not tax dividend income at all. Below is a chart of some of the higher tax rates in the foreign dividend world:

U.S. investors are a bit spoiled in that an overwhelming majority of dividend-paying stocks adhere to a strict schedule and try to keep payouts consistent. In the foreign market, this luxury is not always afforded; some stocks do not have a scheduled payout or set amount at all, making them difficult to rely on for income purposes.

Be sure to also see our full list of Foreign Dividend Stocks.

Investors will also want to keep in mind regulatory differences, especially when it comes to financial reporting and accounting. The U.S. is especially stringent in its standards for reporting key financials to shareholders, but this does not always hold true beyond its borders. This can make it very difficult and time-consuming to get an accurate view of certain stocks. When in doubt, your time can be used more efficiently looking for investments elsewhere. With a little due diligence, patience, and practice, any investor can utilize foreign dividend stocks to add to their investment returns.

It can be easy to see a high yield on a stock and immediately gravitate towards that figure. The problem with that mindset is that a stock with a high yield can often come with significant setbacks. A yield may simply be high because a security is underperforming, watching its price fall while its yield rises. A high yield won’t do much good if your capital base is constantly depreciating.

Read more about the 6 Signs of Unsustainable Dividend Yields.

As Commandment 4 points out, payout ratio is another stat that investors need to look at when faced with a high yield. Perhaps the company is utilizing an unsustainable payout ratio to entice investors, in which case you are better off somewhere else. There are certainly times where a company can maintain a high dividend yield on a consistent basis, but investors should always approach a strong yield with caution; make sure to do your due diligence to ensure that the dividend is consistent, sustainable and the company itself is on stable ground.

Dividend raises for securities in your portfolio are essential when it comes to compounding returns. But a constant dividend raise can also be the sign of a healthy company. Books can be cooked and clever reporting techniques can misrepresent how a firm is actually performing, but a cold hard cash dividend simply cannot be faked. A company that constantly raises that payout is often well-managed and stable. Even if the raise is just a few pennies per year, the results can add up quickly as time goes on.

The chart below shows the payout history for Coca-Cola (KO ), a 50-year dividend grower, from its 1996 stock split through its 2012 stock split:

It should be noted that there is a drawback to a company with a history of raising dividends, as it creates more pressure to keep up those raises as time goes on. In some cases, this pressure can lead to riskier habits in order to meet investor demand, which is why you always want to keep your eye on the financials of a firm to ensure that dividends are still generated by strong earnings.

As we have stressed, dividends are one of the most important parts of investing, but they are certainly not the end-all metric to abide by. There are a number of fundamentals behind every security that make it the right or wrong choice for you, many of which have nothing to do with the dividend payout. Things like price action, earnings growth and profit are just a few of the key attributes investors need to pay attention to.

Be sure to read Myths and Facts About Dividend Investing.

An attractive yield will certainly draw the eye, but never invest on yield alone. To ensure that you are making sound investments, always look under the hood of a potential security and ensure that you understand how that company operates and its position for the future. A solid company will often lead to a strong dividend, but a strong dividend will not always lead to a strong company.

Some things in life are simply too good to be true, and such is the case with certain dividend stocks. Enter a value trap, a phenomenon where a dividend yield looks strong and a stock looks cheap because its price has been dropping, except the price has been dropping for legitimate reasons, making the stock look like a false buy. The first sign of a value trap is a company paying out far more than its peers. Excessively high payout ratios as well as falling cash flows with stable yields are other signs of value traps.

Learn more about How to Spot a Value Trap.

Below, we use J.C. Penney (JCP ) as an example of a value trap that burned famed investor Bill Ackman and his hedge fund Pershing Square Capital Management. After watching JCP’s stock price decline and its yield bump up, Ackman thought he had spotted a great value play, but the results showed that he fell into a harsh trap.

After watching his investment underperform the market, Ackman finally called it quits, losing upwards of $450 million, approximately half of his initial investment. Value traps can reel in even the savviest of investors, which is why investors need to be especially careful about investing in a stock that shows some of these classic signs.

See also The Biggest Dividend Stock Disasters Of All Time.

One of the nuances of the dividend industry is a company’s ability to initiate a special or one-time dividend payout. For those who do not keep a keen eye on these payouts, a stock can seem much rosier than normal. A great example comes from Microsoft (MSFT ), which issued a large special dividend in 2004. Below is a chart of MSFT’s dividend payout history, helping to illustrate just how large and out of the ordinary the special dividend was.

Obviously there is a stark contrast between the standard dividend and the one-time payout. One thing investors need to look out for is yield statistics. A number of resources will calculate this special payout as if it were annual yield, or include it in the 30-day SEC yield, another popular statistic for dividends. If you were to include that special dividend, MSFT’s annual yield for 2004 would have been 13.78%, versus the 0.36% payout from regularly scheduled dividends – a stark contrast.

Investors should also bear in mind that not all dividends come in the form of cold hard cash; stock dividends, though not as frequent, are sometimes utilized. While receiving additional stock over cash may be fine for some investors, it can hurt others that were relying on the income. When picking the right dividend payer for you, be sure to always look through historical payouts on our ticker pages to get a better sense for the habits and behaviors of each company and its respective payouts.

Getting started with dividend investing can be a little intimidating at first when you consider all of the moving parts at hand. For beginners, it’s important to take the time to understand basic concepts, like all of those outlined in this article, before moving onto more involved strategies. Remember that investing is a lifelong learning process and you can get started off on the right foot by educating yourself prior to making an allocation.

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