Question on Dividend Stocks or Funds

[modhatter]

I am fuzzy on a point concerning stocks that pay decent dividends. I hear that good dividend stocks usually raise their dividend each year. However, I feel I must be missing something. If they raised their dividend rate each year the 8 to 10% I read about each year, then it would appear that dividends would grow quite rapidly after ten years or so, and not remain at the historical 2 to 3 % that they are now yielding. Example: If a stock is currently paying out a $2.80 % yield and that yield is increased the following year by 8%, then the following year it would yield $3.02, and so on. I know I am not looking at this correctly, so can someone clear it up for me. In addition, I hear that when the stock falls, that the dividend is usually raised. Example: Your $100,000 in XYZ Dividend stock drops to $75,000. So instead of paying 3% before it dropped they may now elect to raise the dividend yield up to say 4% (yielding the same return as the $100,000 before it dropped) Has that been anyone's experience?


Also, as far as growth goes. I know that those funds or stocks that pay out better than average dividends ($3 to $4 range) do not grow nearly as fast as those that do not. Can any of you who purchase dividend stocks or funds shed some light on the "growth" factor of these funds each year (as well as your yield) Growth is obviously a factor as well as yeild, or why bother being in stocks to begin with.

I have read one book on it so far, and have just ordered a second one.

 

[brewer12345]

On the dividend growth/yield confusion:

- Companies that raise their dividends over time tend to stay at about the same yield despite the higher cash payout. What happens is that the stock price appreciates enough to lower the yield, based on the historical yield demanded by investors as applied to the new cash payout. So your company now paying $3.02 would see its stock price rise by 8%, assuming there were no other effects (like investor expectations, interest rates, inflation, the price of tea in China, etc.).

- The basic expectation is that earnings growth only comes from capital investment. So if you don't raise new capital via issuing debt or new shares, and you pay most/all of your free cash out, tere isn't capital left over for growth.

 

[grumpy]

Modhatter,

Let's see if I can make this clear with a few examples:

First, the dividend yield of a stock is equal to the dividend amount divided by the stock price. So a stock that pays a $1.00 dividend and that sells for $50 has a dividend yield of 1/50 = 2%. This is called the current yield.

If either the dividend amount or the stock price changes, then the current dividend yield also changes.

The reason that the stock of a company with a history of raising divdends is so desirable can be seen from the following comparison:

If I buy 100 shares of the stock shown above at a price of $50 I will have a yield of 2%. Next year the company raises the dividend to $1.10. At that time the stock price is $55. For someone who buys the stock then, the yield is still 2%. However, for me the yield on my investment of $5000 has grown to 2.2%. Also the value of my pricipal investment has grown to $5500. If I am not continuing to buy shares of this company then the current yield doesn't mean that much to me. What counts (if I am a buy and hold investor) is the yield on my original investment. If the dividend continues to be raised, my original cost basis remains $50 and the yield on my initial investment continues to rise. This is true even if the current stock price falls to $40 per share or rises to $60.

Compare that to a CD that yields 2%. I invest the same $5000 in the CD. A year later the principal amount is still $5000 and the yield is still just 2%.

Brewer12345's comment relates to the current yield, which may not increase much, due to an increase in the stock price that often follows a dividend increase. I like to look at the dividend yield on my original cost basis. For many of my stocks this has grown to double digits (e.g. Bank of America = 10.2%, Washington Mutual = 13.9%, etc.). This is the yield that I look at to decide if I can get a better return somewhere else. In other words could I take that original $5000 ( plus any growth of principal) and buy a different stock whose current yield times the number of shares that I could buy produces more dividend dollars per year than the existing stock? If not, then I happily collect my effective double digit yields.

I have built a portfolio of these types of stocks currently worth over $200K. The effective yield on the whole portfolio is over 5%. I did this originally with DRIPS and reinvested all of the dividends.. It was fun to do. Now that I am retired I take the dividends in cash.

Hope this helps.

Grumpy

 

[modhatter]

Grumpy, that was a wonderful explination. Now I understand the concept. Thank you so much for taking the time to explain it. Believe it or not, I read a whole book on the subject and they never really explained how it worked.

 

[maddythebeagle]

Very good explanations. I am also building a port of drips with increasing dividends, but it seems like I have to put a lot of educated guesses where the port will be in 10-30 years. I would have guessed that your dividend rate would be higher than 5% on a port of over 200k? Is that because some of your holdings were recent purchases?

 

[laurence]

Modhatter,

Let's see if I can make this clear with a few examples:

First, the dividend yield of a stock is equal to the dividend amount divided by the stock price. So a stock that pays a $1.00 dividend and that sells for $50 has a dividend yield of 1/50 = 2%. This is called the current yield.

If either the dividend amount or the stock price changes, then the current dividend yield also changes.

The reason that the stock of a company with a history of raising divdends is so desirable can be seen from the following comparison:

If I buy 100 shares of the stock shown above at a price of $50 I will have a yield of 2%. Next year the company raises the dividend to $1.10. At that time the stock price is $55. For someone who buys the stock then, the yield is still 2%. However, for me the yield on my investment of $5000 has grown to 2.2%. Also the value of my pricipal investment has grown to $5500. If I am not continuing to buy shares of this company then the current yield doesn't mean that much to me. What counts (if I am a buy and hold investor) is the yield on my original investment. If the dividend continues to be raised, my original cost basis remains $50 and the yield on my initial investment continues to rise. This is true even if the current stock price falls to $40 per share or rises to $60.

Compare that to a CD that yields 2%. I invest the same $5000 in the CD. A year later the principal amount is still $5000 and the yield is still just 2%.

Brewer12345's comment relates to the current yield, which may not increase much, due to an increase in the stock price that often follows a dividend increase. I like to look at the dividend yield on my original cost basis. For many of my stocks this has grown to double digits (e.g. Bank of America = 10.2%, Washington Mutual = 13.9%, etc.). This is the yield that I look at to decide if I can get a better return somewhere else. In other words could I take that original $5000 ( plus any growth of principal) and buy a different stock whose current yield times the number of shares that I could buy produces more dividend dollars per year than the existing stock? If not, then I happily collect my effective double digit yields.

I have built a portfolio of these types of stocks currently worth over $200K. The effective yield on the whole portfolio is over 5%. I did this originally with DRIPS and reinvested all of the dividends.. It was fun to do. Now that I am retired I take the dividends in cash.

Hope this helps.

Grumpy

I only began my investing in dividend stocks a few months ago (thanks, TH) and I'm already in love! Great explanation.

 

[maddythebeagle]

Turning over your portfolio in the search of higher yields doesnt make any sense to me. You lose your capital gains tax deferral and take on selling fees. Besides, the idea of dividend port. is to take the dividends as income and leave the rest to grow. If you need the extra income, selling some shares would do it. Why then turn around and buy other shares?

 

[grumpy]

I would have guessed that your dividend rate would be higher than 5% on a port of over 200k? Is that because some of your holdings were recent purchases?

Maddy,

Yes, that's part of the explanation. I also have to leave out certain stocks. For example, I bought Altria (Philip Morris) in 2000 at $19 per share. It is now at $73. I have sold shares that more than equal my original investment. So the calculation of dividend yield of the remaining shares on my initial investment gives an infinite result. Therefore, I leave this stock out of my calculation for the whole portfolio. I occasionally rebalance my portfolio when a stock comes to represent too large a share of the total ( like MO). So I have several stocks with infinite calculated yields on original investment. I also have several tech stocks (Intel, Texas Instruments) in the portfolio that pay very small dividends.

Grumpy

 

[grumpy]

Turning over your portfolio in the search of higher yields doesnt make any sense to me. You lose your capital gains tax deferral and take on selling fees. Besides, the idea of dividend port. is to take the dividends as income and leave the rest to grow. If you need the extra income, selling some shares would do it. Why then turn around and buy other shares?

Maddy,

Yes, I do have to pay the 15% capital gains tax but I can usually offset most of this by selling losers elsewhere in my other accounts. The selling fees are not an issue. I use Buy & Hold Securities. For $7 a month you get two free trades. In months when I want to do more trading I can switch to the $14 per month plan that gives unlimited trades and then switch back.

Grumpy

 

[modhatter]

So, to clarify this. The yield only or income (which ever is correct) from your original investment really stays somewhat constant in relation to the current (increased) value of the stock. It only goes up in relation with what you originally paid for the stock.

So, in reality, since when we retire we look at our total value of our portfolio (say for argument sake $1,000,000) and if we needed $40,000 annually to live (4%) draw, then the only difference between having a dividend yielding portfolio, and a regular stock/bond portfolio, is that the dividend portfolio would not neccessitate the selling of stock to obtain the $40,000. Is this a correct assumption.

As I see it, the problem with a stock portfolio, especially in the early years of retirement (no matter how well balanced and diversified) is that is a retire is unfortunate enough to start his retirement with a series of very bad years, this will severly damage his future earning prospects of his portfolio.

Now to further understand. In that same scenerio. If you had a portfolio of primarily dividend paying stocks or funds and these funds also dropped significantly with the market in the first few years or even seven years of retirement, then are your prospects better, as you can still collect the dividend to live without selling off your depleted stock portfolio.

What happens to the dividend when you buy it for $50 a share, yielding 2% or $1.00, and that stock drops down to $30 a share in a serious downturn? What happens to your dividend income then?

 

[Nords]

Now to further understand.  In that same scenerio.  If you had a portfolio of primarily dividend paying stocks or funds and these funds also dropped significantly with the market in the first few years or even seven years of retirement, then are your prospects better, as you can still collect the dividend to live without selling off your depleted stock portfolio. 

This is why there are so many foodfights over retirement investing. You've just described the income investor's philosophy of never having to dip into the principal.

Conventional wisdom claims that you'll need more savings (one estimate is approx 33x instead of 25x your expenses) to realize the same inflation-adjusted returns over the same multi-decade retirement as a retiree who's consuming their portfolio. I believe TH has adopted a high-equity income portfolio-- hey, fella, jump in here and help out!

What happens to the dividend when you buy it for $50 a share, yielding 2% or $1.00, and that stock drops down to $30 a share in a serious downturn? What happens to your dividend income then?

There are a couple scenarios:
1.) Nothing. You're still receiving $1/share in dividends, although now the stock's advertised yield has soared to 3.33%. Surely the high dividend is going to attract large institutional buyers and make the price zoom up to $60-- any day now. "Stay the course."

2.) You're still receiving $1/share in dividends but everyone decides that this stock is in serious trouble-- yielding 3.33% and still "dropping". Soon it's a $20 stock yielding 5%... then an $18 stock yielding 5.56%... then Moody's jumps in to downgrade their bonds and their credit, S&P downgrades their recommendation, and Warren Buffett starts sniffing around. "Stay the course" because your income hasn't changed. (But it could! See scenario #3.)

3.) The company is struggling with a crappy year (the reason that the stock dropped in the first place) and they've spent all their cash reserves. Then they realize that their dividend is up to 3.33% but more importantly their dividend payout is soaring to 110%. Panicking In firm control of the situation they "temporarily" cut the dividend to 2% until prospects improve. The yield has returned to "normal" but now instead of $1/share you're only receiving 60 cents/share. You'd like to sell the stock but it's down 40%. Now what?

 

[laurence]

This is why there are so many foodfights over retirement investing. You've just described the income investor's philosophy of never having to dip into the principal.

Conventional wisdom claims that you'll need more savings (one estimate is approx 33x instead of 25x your expenses) to realize the same inflation-adjusted returns over the same multi-decade retirement as a retiree who's consuming their portfolio. I believe TH has adopted a high-equity income portfolio-- hey, fella, jump in here and help out!
There are a couple scenarios:
1.) Nothing. You're still receiving $1/share in dividends, although now the stock's advertised yield has soared to 3.33%. Surely the high dividend is going to attract large institutional buyers and make the price zoom up to $60-- any day now. "Stay the course."

2.) You're still receiving $1/share in dividends but everyone decides that this stock is in serious trouble-- yielding 3.33% and still "dropping". Soon it's a $20 stock yielding 5%... then an $18 stock yielding 5.56%... then Moody's jumps in to downgrade their bonds and their credit, S&P downgrades their recommendation, and Warren Buffett starts sniffing around. "Stay the course" because your income hasn't changed. (But it could! See scenario #3.)

3.) The company is struggling with a crappy year (the reason that the stock dropped in the first place) and they've spent all their cash reserves. Then they realize that their dividend is up to 3.33% but more importantly their dividend payout is soaring to 110%. Panicking In firm control of the situation they "temporarily" cut the dividend to 2% until prospects improve. The yield has returned to "normal" but now instead of $1/share you're only receiving 60 cents/share. You'd like to sell the stock but it's down 40%. Now what?

It's number 3 that has kept me from doing more than Vanguard Value Viper. Still get almost 3% with diversification.

 

[grumpy]

I deal with scenario #3 by holding 20 to 25 dividend paying stocks, none of which constitues more than 7.5% of my portfolio. A dividend cut in one stock does not materially affect my total dividend income. If you follow your companies closely, there are usually some signs that the dividend my have to be cut. You then have a choice to sell before the price drops further or to hold on for the expected recovery. In my experience, when I have sold stocks whose dividends have been cut, I later regretted it because the dividend was later restored and the stock price recovered. Examples, Chemed, Brown Shoe, PECO, etc.

Grumpy

 

[maddythebeagle]

Good post Grumpy. I also hold 30+ drips and the only one that had the dividend cut was when I first started it and I dca'ed it for a few years now and it has recovered with a nice gain. The problem was a short-term issue, which means buy some more shares. Yes, it is more work to follow individual companies, but I believe that there are some real advantages to it (can spot the times to be contrarian) and some folks think it is fun. My biggest investment is still in index funds in my 401k plan, though.

 

[yakers]

Yes, it is more work to follow individual companies, but I believe that there are some real advantages to it (can spot the times to be contrarian) and some folks think it is fun.

Maddy (& Grumpy whose pattern I seem to follow). I have all of 6 DRIP stocks as well as my IRas/TSP. These are about as may as I can track and understad. Maybe I could add a couple but 25 to 50 seems a lot. Do you folks really study your stocks or rely on diversifacation for safety? Or is it a case that there are a lot of safe dividend paying stocks if chosen reasonably optomizing rather than maximizing?

 

[grumpy]

Do you folks really study your stocks or rely on diversifacation for safety? Or is it a case that there are a lot of safe dividend paying stocks if chosen reasonably optomizing rather than maximizing?

Yakers,

I do follow my 20 to 25 stocks and their industries. I subscribe to the on-line version of the Wall Street Journal and I read it most days. I track my portfolio on that site, which posts all news articles and press releases for the companies in the portfolio. You do need to watch the companies carefully even if they seem to be "safe". For example, I sold all my shares in Allstate as soon as the magnitude of the damage in the Gulf became apparent. I have reinvested that money into some of my other dividend paying stocks. Now that Rita is headed toward Texas, Allstate has fallen even further.

I occasionally look up each stock in Value Line at the public library. This can be time consuming but I enjoy it. I spend less time on this now that I am no longer in the accumulation phase.

If you don't have the time or interest to follow the companies and industries, then I recommend you stick with mutual funds.

Grumpy

 

[Nords]

For example,  I sold all my shares in Allstate as soon as the magnitude of the damage in the Gulf became apparent.  I have reinvested that money into some of my other dividend paying stocks.  Now that Rita is headed toward Texas, Allstate has fallen even further.

Berkshire Hathaway seems to be on sale this month, too, even though they only have a fraction of the Katrina damage and probably even less of the upcoming Galveston damage. With $40B in cash and owning all sorts of mobile home & contruction-material companies, I suspect they're well positioned to benefit from the aftermath.

 

[brewer12345]

Berkshire Hathaway seems to be on sale this month, too, even though they only have a fraction of the Katrina damage and probably even less of the upcoming Galveston damage.  With $40B in cash and owning all sorts of mobile home & contruction-material companies, I suspect they're well positioned to benefit from the aftermath.

They are also the world's biggest P&C reinsurer, and should benefit from what is undoubtedly a much better pricing environment.

 

[cute fuzzy bunny]

Jump in? Sure!

High dividend stocks are "the new bonds". You can get a safe 3% @ 5-15% dividend tax rate (0% starting in 2007), with a good chance of nice appreciation of the base shares. Why take 3-4% @ ordinary income tax rates and plenty of downside risk?

I dont buy individual stocks, I'm holding two vanguard funds that own >500 different companies. Hence I'm not that worried about a handful tanking and taking the dividend with them.

By historic data, I'll make my 3% plus 6-8% annually in price appreciation, at least over longer terms.

You can hand pick 20-30 stocks and get good enough diversification. I'll let someone else do the work for ~20 basis points a year in expenses...

 

[ats5g]

Just thought I'd throw this out. From Aswath Damodaran of NYU:

HIGH DIVIDEND STOCKS: BONDS WITH PRICE APPRECIATION?

I'll duck now.

- Alec

 

[maddythebeagle]

Interesting thanks. I havent done the "Dogs of the Dow" thing, but I always thought it was more a contrarian idea and worked because the highest yielding stocks were the ones that had stock price declines from bad news and bad news usually knocks a stock down lower than its value.

 

[cute fuzzy bunny]

Do note that over time, "bad stocks" were good stocks to own, and "good stocks" were bad stocks to own.

 

[yakers]

Do note that over time, "bad stocks" were good stocks to own, and "good stocks" were bad stocks to own.

Another way to look at this is over a long time owing all stocks (TSM) is pretty good and fairly safe. Of course that means all of 1% dividends these days plus some growth.

 

[cute fuzzy bunny]

A true statement, however a well diversified portfolio of value stocks beats the pants off of the TSM returns over longer term periods of time, plus pays you ~2.5-3.5%+ in low tax cost dividends.

More volatility in short term periods, but if that makes you nervous, buy other stuff.

 

[ats5g]

Vanguard jumping on the Bandwagon:

New Dividend Acheivers Index fund.

Where the he** is the int'l bond fund or microcap fund!!!

- Alec