In Brief 

Dividend investing is a strategy that focuses on generating gains from dividend income, rather than capital growth. Historically, dividend payouts were a primary motivation for investors (Wharton School of Business professor Jeremy Siegel has pointed out that over 90% of the gain of the Dow since 1900 has been from reinvested dividends), but this mode of investing largely fell out of favour during the 1982-1999 bull market, as company valuations rose dramatically for such a sustained period.

Background

While the Board may always opt to change the dividend, dividends are usually set at levels low enough to be able to sustain payment throughout the economic cycle (because dividend cuts are regarded as implying financially distress). Dividend stocks have sometimes been disparagingly referred to as ‘widow and orphan’ stocks as a reflection of their stable nature. However, after more than a decade of stock market volatility, low bond yields, and stagnant money markets, it’s increasingly not just widows and orphans who see them as a key source of steady growth for their portfolios. As government debt hampers the growth of GDP in many developed countries such as the UK, dividend Investing is likely to return to popularity over the next few years. Among other things, dividend-paying stocks:

  • Offer passive income & some insurance if the stock falls in price  (unlike non-dividend-paying shares where returns aren't realized until you sell);
  • Tend to be less volatile and do better in the long run than do nonpaying stocks (see S&P research below)
  • Are subject to more stringent financial discipline, since they must make regular  payments to shareholders. You can fudge earnings but you can't distribute cash returns to your shareholders if you don't have the money.
  • Offer an inflation hedge if companies increase their payouts.

As David Stevenson notes, there are several schools of thought on how to approach dividend investing. One school maintains that a good dividend yield and a strong balance sheet should outweigh any consideration of future earnings growth. Another school of thought  suggests that the yield isn’t quite as important as the potential for growth to accelerate compounding in the dividend.

Definition of a Dividend Screen

A popular approach to a dividend screen is simply to look for stocks with the highest dividend yield – the dividend divided by the original purchase price. This is often applied to stocks in a large…

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