The Appeal of Investing in Dividend Stocks
As a growth investor, I’ve never been interested in dividend stocks. In fact, I’ve always thought that dividend stocks were for people that have given up on trying to make big returns in the stock market. Well, given the lack of performance of growth stocks over the past decade, I’ve started to reconsider. So, in this article I’ll make a case for why dividend stocks are good investments. However, first I’ll go over the reasons that I have personally shunned dividend stocks.
Why I Don’t Like Dividend Stocks
Generally, a fast growing company needs to put all of its cash flow back into its business to fund future growth or make acquisitions. These reinvestments of capital are what usually keeps the company and the stock growing rapidly. That means that a company that pays dividends has run out of growth, or cannot find enough good investments for its cash. Therefore, the company decides to pay the cash back to investors. And after all, the reason that we invest in stocks is because they are better investors than us, right? For example, let’s say you have $100,000 to invest. You can either start your own business or invest it in an established business (through stock). Most people choose to invest in a business that is already established. You can do so easily by buying stock. The reason you buy stock in a company is because the business is growing and you believe the value of the stock will go up along with the growth. So, in essence, you give your money to a company to manage for you and invest in their company. So, when looking at it this way, why would you want that company to give you part of your money back? I mean, didn’t you give it to them to invest? By paying out dividends, a company is foregoing growth. That is the key reason that I have always shunned dividend stocks. However, there is also a case to be made in favor of dividend stocks.
Why Dividend Stocks Can Be Good Investments
Generally speaking, I still agree with the reasons above against dividend stocks, however, there are hundreds of dividend paying stocks that are still growing rapidly. It is these growth / dividend stocks that I find appealing and here are some reasons why.
First, if you buy a dividend stock that is growing, both your cash flow and your portfolio will grow. Look at a dividend stock like McDonalds (ticker MCD). Ten years ago the stock was at $30 per share and they paid a 23 cent dividend. Over a ten year period, their dividend rose over 1,000% to $2.80 per share and their stock has more than tripled. If you had bought a thousand shares of stock ten years ago you would have paid $30,000. Today, the stock value would be nearly $100,000 and you would be earning almost $3,000 per year in dividends. Furthermore, you would have recieved over $13 per share in dividend payments, which would be the equivalent of $13,000!
Second, sometimes companies have extra cash because they are just highly profitable, not because they aren’t growing rapidly. While its generally true that companies start paying dividends when their growth slows, it doesn’t mean that a company that pays dividends isn’t still growing. Some companies are just very profitable. Companies with large profit margins have more difficulty investing all of the excess cash flow, and sometimes prefer to focus on growing their existing business rather than investing in new businesses. For this reason, it makes sense that some of these companies pay out excess cash in the form of dividends. For example, long time growth stock Cisco Systems, the icon for growth over the dot com boom, now pays a dividend. Cisco is a highly profitable company with gross margins over 60% and operating margins over 20%. For a company that generates that much cash flow, it is hard to fully invest all of that cash and still focus on the business at hand.
Third, companies that offer dividends do so for the long term and are typically focused on longer term metrics. The one thing that all dividend stocks have in common is that they are commited to paying dividends. Once a company starts a dividend policy, their main investor goal is to continually and consistently raise their dividend. That means that they will do whatever they can to keep paying larger and larger dividends. These companies know they have a specific type of investor interested in their company and that missing a dividend would result in a lot of upset investors. Companies that pay dividends understand that investors want long term consistency in both dividends and company performance. That is part of the reason that dividend stocks are more stable than other stocks. Management is able to focus on the long term rather than just trying to beat analysts’ growth estimates for the next few quarters.
Fourth, during poor markets, your yield actually increases. Part of the reason that dividend stocks are attractive, is because they offer dividend yields. So, what happens to your dividend stock investment when the market tanks. Let’s say you own McDonalds stock, which currently yields 2.8% ($2.80 dividend and $100 stock price). Now, let’s say the market has a huge sell off and all stocks fall 50%. It’s true that you lost the same amount of equity as non-dividend portfolios, however, the good news is that your yield has doubled. Because the dividend doesn’t change and the stock price does, your yield will climb when stock prices fall. Also, because of the yield, dividend stocks often fall less during bad markets than other stocks, especially growth stocks. Both of these factors can help you weather down markets more easily.
Finally, dividend stocks are good for those looking to buy and hold. I have been a real estate investor in the past and kind of relate dividend stocks to real estate. When you buy real estate, you are hoping to be somewhere around breakeven on cash flow. Hopefully making a few bucks a month. However, as you hold your real estate your costs do not increase very much but hopefully your rents and property value do. This means that your cash flow will grow over time. The same can be said for dividend stocks. Buying a dividend paying stock today will not likely yield more than a few percent, however, in dollar terms, that dividend, or cash flow, will continue to grow overtime. If you hold dividend stocks long enough, your dividends may eventually add up to as much as the price you initially paid for the stock.
We hope this has given you some fresh insight into dividend stocks. We know that each individual investor favors certain aspects of different investments. That’s why no one investment is perfect for everyone. However, with this insight, we hope to shed some light on how you look at dividend stocks in the future. If you have any comments or additional insight, please leave us a comment below.