Looking for a stock that regularly pays you money? Then a dividend stock may be for you.
Continue Reading Below
You may think dividend-paying companies are slow-growth firms that don't have anything better to do with their cash. But history has shown that investors get a better return when investing in dividend stocks.
"There are a lot of statistical studies showing dividend-paying stocks outperform nondividend stocks," says Josh Peters, director of equity-income strategy at Chicago-based Morningstar Inc., which provides investment research. "Companies that pay dividends have better established competitive positions and a better return on their capital."
A dividend is a distribution of earnings to the shareholder, usually as money or stock, but it also takes other forms. It is sent quarterly or annually by the company's board of directors.
While high-flying growth stocks may afford you an opportunity to make money on the quick, there's also risk that the company can implode, leaving you with nothing. That's not to say a dividend-paying company won't slash its dividend. After all, most big banks did that last year, though they usually have the competitive lead, cash and the ability to withstand market gyrations.
Dividend Stocks not Created Equal
The dividend payout ratio is the percentage of earnings paid out in cash. In general, the higher the payout ratio, the more mature the company. Electric and telephone utilities tend to have the highest payout ratios, whereas fast-growing companies usually reinvest all earnings and pay no dividends.
But not all dividend-paying companies are created equal. Some have low dividend yields of 2% to 3% of earnings while others pay a higher yield of 5% to 7%. In a class of its own are those dividend stocks that pay a double-digit yield. With the latter group, the reward is bigger, but the chance that the dividend will get cut is also greater.
"Because a company pays a high dividend rate does not mean it's a very successful company," says Thomas Breiter, president and portfolio manager of Breiter Capital Management Inc., in Anna Maria, Fla. "It could be the stock price has dropped resulting in a high dividend yield."
Breiter says when it comes to dividend investing, there are two camps: those who invest for the high yield and those who buy stocks that pay a lower dividend today, betting it will increase down the road.
No matter which way you choose to invest in dividend stocks, financial pros say to look for those companies that have enough cash flow to sustain their dividends, have a long history of paying a dividend and have shown a propensity to raise it on a regular basis.
So what sectors and stocks should you consider when creating a dividend-paying portfolio of stocks? According to investment advisers, there's a slew to choose from in both camps.
Cigarette companies may not be in favor, but they pay a healthy dividend, making them attractive to those who want to get a good payout on their investment. According to Harry Domash, publisher of the DividendDetective.com, a website for dividend investors, cigarette stocks are paying dividend yields of 6% to 7% and have little risk of being cut.
Master limited partnerships in the energy sector, Domash says, also pay out a high dividend and have little risk. They trade on the stock market but get the tax advantages of limited partnerships. Domash says most of them own natural gas pipelines and pay a dividend yield of 6% or 7% of earnings. While natural gas prices are falling, usage is increasing, hence increasing volumes processed and transported.
If a dividend yield of 6% to 7% isn't high enough for you, there are some industries that have dividend rates in the double-digit range. Take mortgage-related real estate investment trusts, or REITS. These are companies that invest in mortgages insured by Freddie Mac and Fannie Mae, the government-backed mortgage companies. Domash says mortgage-related REITS typically pay a 15% to 20% yield, although they operate in a risky area of the market.
Mortgage REITS that invest in mortgages backed by commercial properties lose money if the mortgages go into default. REITs that invest in residential mortgages insured by government agencies don't have to worry about defaults, but because they borrow funds that they invest at short-term rates, their earnings suffer when short-term rates rise.
"The higher the risk business, the higher yield you'll get," he says.
While a dividend may be high, Morningstar's Peters says typically the market is signaling that there is an "extreme level of risk in the stock" when it reaches that level.
Whether you go with the high payers or steady growers, it pays to have dividend stocks in your portfolio. After all, where else are you going to get paid simply for holding stocks?
"Having some portion of profit dedicated to dividend-paying stocks makes sense," says Colleen Supran, portfolio manager at Bingham, Osborn & Scarborough LLC, a money-management firm in San Francisco. "Right now, returns are very volatile, and this gives you some portion of your return upfront."