Dividend Investing 101

Everything you need to know

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Let’s start with a paradox. Every time Apple pays dividends, it makes headlines, because one of its largest payouts is to the coffers of Warren Buffett’s Berkshire Hathaway. This year, the payout was $214 Million! In 2023 alone, Berkshire Hathaway is expected to make $5.7 Billion just in dividend payments. Buffett has also sung the praise of dividend-paying stocks in the past.

An investment in Berkshire Hathaway would have beaten any other investment on the planet over a number of timeframes. And yet… Berkshire Hathaway has never paid a dividend in its 50+ years. So the question is: Do dividends say something about the quality of the company? Why does Buffett favor dividend-payers while not paying a dividend himself? Most important of all: Can you make money by investing in dividend stocks?

In this article, I’ll be diving deep into the mechanics of dividends, the pros and cons of dividend investing, and what you should keep in mind before you invest. I’ll also be discussing my own dividend portfolio and how it’s performing, in detail.

Why are dividends paid?

The basis of owning shares in any company is that it entitles you to a portion of their profits. Companies can choose to return this profit to their stakeholders in a few different ways:

1. By reinvesting capital into the growth of the business
2. Acquisition of other businesses
3. Repurchasing shares of shareholders
4. Distributing cash as dividends

Which direction a company takes is dependent on both the opportunities it has and its stage in its lifecycle. Growth companies that focus on technology or disruption, or companies that see scope to expand typically reinvest capital. In the long run, this could make the business more competitive and increase the value of the stock. Companies that have a vision for the future and a lot of capital reserves could also acquire other companies that align with their vision.

Buybacks can be great, but they are also controversial, because of the perception that it only enriches executives. This isn’t really true though – with no other viable opportunities, if a company is trading for lesser than its intrinsic value, buying back shares could add value to all shareholders. That brings us to dividends.

Dividends are the simplest option of the lot – The company just returns a portion of the cash to its shareholders and lets them decide what to do with the money. Dividend payers are usually mature and stable companies that have predictable cash flow. The dividend amount is a percentage of the share price, called the “Yield”, and a stable yield year-over-year is seen as an indicator of financial stability.

Dividend investing is one of the easiest ways to generate passive income, and reinvesting dividends can be a powerful way to compound your investments. But others argue that dividends just show a lack of ideas on the company’s part. Let’s dive into both the pros and cons.

The psychological advantage

The biggest advantage of dividends is that you get payouts in cash without having to sell any of your shares. Some argue that this is just an illusion because the money that the company takes to pay out dividends is capital it could have reinvested to grow the stock price. But consider the following scenario:

1. The company is mature and stable, and has no new markets to expand into.
2. There are no attractive acquisition opportunities.
3. The stock is valued fairly or overvalued.

In such cases, forcible reinvestment or share buybacks could be a bad decision – by redistributing profits as dividends, the company is letting its shareholders manage their money for themselves. Assuming you have dividend payers in your portfolio, you can collect the dividends and reinvest them among your holdings as you see fit.

But the bigger advantage might be psychological: If you’re a true value investor, you might have paranoia about selling your shares. After all, the standard advice is to “buy-and-hold”, and even if you really need the cash, you might be anxious about selling a stock you know is doing well. Dividends alleviate this fear by taking away the need to sell and giving you ready cash to spend. The fewer major investing decisions you need to make, the fewer mistakes you are likely to make, and dividends outsource the decision-making to the companies.

But that still leaves the question: Are the returns of dividend stocks better?

Dividends vs The S&P 500

One of the biggest advantages of dividends is predictability. A company cannot control its stock price, but it can control the amount set aside for dividend payments – and it generally remains stable or trends upward. For a stable or mature company, the dividend payout is a means of signaling financial stability, so such stocks could lead to predictable cash flow (more on where to look for these later).

As evidence to back this up, let’s look at how dividend payments have compared over the last century: From 1900 to 2018, dividend payments remained fairly constant, and had an average variance of just 10% during market downturns.

But the S&P 500 had much higher volatility in the same period. If predictability and consistency in cash-flow are your priorities, then lower volatility goes a long way. Don’t get me wrong – long-term investing is the wiser course of action to build lasting wealth, but it might not be a source of cash for you to tap into for a long time. Dividend-paying companies on the other hand are larger, more mature, and prioritize stability – so they could be a better choice for regular cashflow.

The larger cash reserves of stable companies mean that dividend payments take a smaller hit and sometimes increase during recessions at a time when other companies struggle to stay afloat. According to Simply Safe Dividends, dividends paid to investors increased in three recessions, with a 46% jump during the recession following World War II.

Finally, dividends accounted for 54% of market returns during times when inflation was above 5% – and dividend stocks have been shown to provide a comparable return to the overall market. Though they might not be the stocks that benefit the most from bull runs, dividend stocks also do not decline the most during a crash.

But there are good reasons for people to argue against dividend investing as well. You need to be aware of those…

The Dark Side of Dividends

The biggest problems with dividends have to do with dividend policy and payouts: Dividends are predictable and generally stable, but they are not guaranteed in any way. If the cash-flow of a company is threatened, they might suspend dividend payouts till the situation improves.

Dividend yields are also meaningless when the stock price itself declines – a 5% yield would lose you money when the stock itself declines by 30%, and that has happened on multiple occasions. 3M lost more than 55% of its value in the last 5 years making their 5.6% yield worthless. There’s always a chance that stock prices could bounce back, but these situations cancel out the consistency advantage of dividends.

Taxes are also a tricky area when it comes to dividends. If you’re single and make less than $41,000 a year or married making less than $83,000 a year and receive what’s called a qualified dividend – there’s absolutely no tax on this profit. Beyond this amount, some dividend income is classified as “long-term capital gains”, which is much lesser than what you’d pay on your income.

But if you start making more money, dividends give you less control over your taxes. When it comes to stock price appreciation, you pay taxes only when you sell, and the amount that you save is reinvested and compounded over years – this can add up to large amounts. But dividends are taxed immediately on payout, and if your income increases, the taxes could go to 20% or higher. Dividends are also taxed twice, first on the corporate level as profit, and then at your end. It’s a “waste” of money for both the company and you if there are better opportunities to invest.

And then there’s also the argument that dividends really have no financial edge – that it’s purely psychological. No value is created or destroyed in the process of paying out dividends, and all it does is save you the decision-making about selling the stock. Instead of getting a 5% yield, you might have gotten a 5% yield if the capital had been invested efficiently.

Despite all this, I lean towards holding some portion of my portfolio in dividend stocks. Here’s how I’ve allocated my money and how you can figure out the amount of dividend income you need to live comfortably:

My portfolio

My dividend income is about $10,000 per month. There are 5 major chunks across which I’ve split my money.

1. $3.8 Million in a Broad US Market ETF, SCHB
2. $900,000 in an international Equity ETF, SCHF
3. A variety of individual stocks

The broad US Market ETF has a dividend yield of 1.56%. It includes 2,500 of the largest publicly traded US companies. Though this has slightly higher exposure to smaller companies than the S&P 500, it’s market-cap weighted and the difference isn’t significant. But the $3.8 million dollars I’ve invested bring in about $5000 per month in passive income.

The International equity ETF, SCHF, is a fund that includes large and mid-cap stocks from developed countries abroad including Nestle, Samsung, Shell, Toyota and about 100 others. The $900,000 invested here gets me some international exposure and brings in an additional $2000 per month.

The individual stocks are judgement calls, and they are purely to satisfy my desire to feel like I might have a chance of beating the market. Financially speaking, it would have been a better decision to just invest into the S&P500, but I’ve restricted my investments to these:

1. Walgreens. It pays a dividend of 5.6%. But though the 5,000 shares I own bring in about $800 a month, the price only seems to go down.
2. The Cheesecake Factory. I bought this at a “pandemic discount” when it was trading under $20 a month. It pays about $150 a month at a yield of 2.9%.
3. A mix of some large stocks like Apple, Ford, JP Morgan, Simon Property Group, Bank of America, McDonald’s, ATT, Ally, Microsoft, Exxon, and a few others in varying amounts which pay between a 1-6% yield each. I have another $600,000 invested throughout these.

That brings my monthly dividend total to $9,400 per month or about $112,000 per year, regardless of what happens to the share price. (These are not recommendations, and if you are planning to invest in individual stocks, please do your own research and consult with a licensed financial advisor before making any decisions)

Do you invest in dividend stocks? Which ones and what has your experience been?

If you had to live a life based exclusively off dividend income, how much would you need to invest? Is it possible?

How much is enough?

That’s the question you need to answer first, because the dividend income you need would be based on your lifestyle: Do you live in a penthouse in New York, on a ranch in Texas, or off-the-grid in a tiny home in Montana? That would determine your expenses. But let’s take the average retiree, who spends about $50,000 a year as our baseline and plan from there.

Next, when you’re looking to build a portfolio, you shouldn’t go for the highest yield. Instead consistency is something you could take into account – and that brings us to the Dividend Aristocrats. This is an intersection of quality, stability, and consistency, picking 65 stocks with a history of more than 25 years of consecutive dividend increases. The selection is itself based on their growth, size, and ability to continue raising their payouts.

The track record has been impressive, with only 2 years of negative growth in the last 20 years (in 2008 and 2018). Other than that, the Dividend Aristocrats have continued growing above and beyond the average. A good portion of these companies also outperform the market through recessions – even if they decline, it tends to be much lesser compared to the overall market. Because dividend-paying companies are more cashflow focused and selective with their spending, they are able to weather these tough times and reward their shareholders.

Coming back to the question: How much would you need? Dividend aristocrat yields range from 0.3% to 5.36%, with most being in the 2-3% range. If you took a basket of stocks with an average yield of 3%, you’d need $1.67 Million to secure an income of $50,000 per year. Though that sounds daunting, it’s completely doable by the time you retire – by investing $5000 per year, you could potentially achieve this in 40 years if you reinvest all your dividends.

But one way to hack this 40 year period, for the impatient like me, is to use something called a “Covered Call ETF” like JEPI. This generates income through a combination of selling options and investing in US Large-cap stocks. How much income does this generate? Up to 10.7%! The selling feature of this fund is that it generates a yield regardless of how the market performs, since it pays you based on the premiums it receives for selling call options on its holdings. But there’s a catch – The ETF loses out on the upside at the time the market does well, and if the market goes down, the price of the fund goes down. There’s no such thing as a free lunch.

Hypothetically, you could replace a $50,000 income with a $500,000 investment in a covered call ETF – That’s way more achievable, but way riskier as well. A more prudent approach would be to diversify your holdings through a dividend ETF or a portfolio of dividend stocks though the initial investment required is higher.

Coming back to Warren Buffett’s case, he answers the dividend question himself in his 2012 letter to shareholders. He compares the appreciation in value of a business with and without dividend payouts, and shows that there is a slight advantage in not paying dividends – but the bigger reason he cites is that paying dividends forces a specific cashout policy on shareholders, and also decides the taxation for them. If these factors are favorable to you, you could voluntarily take advantage of dividends.

Money obviously isn’t free – and the dividend payouts are just taken from the cash-flow of the company. The main benefit is a psychological advantage of having cash instead of stake in a company, and predictable income. To me it makes little difference since I just reinvest the proceeds. Thought it’s inefficient in terms of taxes I pay, I have the peace of knowing that I have the money if I need it.

Dividends could be great as a small part of a well-diversified portfolio – but if you’re young and don’t rely on dividends for income, you need not focus on them.

Stay safe, stay invested, and I’ll see you next time – Graham Stephan.

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Disclaimer: This is not financial advice. This information is intended to supplement your knowledge in the field of investing and personal finance. Please do your own research carefully.

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