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The Incredible Flexibility Only Dividends Can Provide

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If the ideal investment is one you can buy and hold forever, then it's almost certainly also one that pays dividends. Dividend-paying stocks can be appropriate to own throughout your investing career, whether you're looking for growth, income, or opportunities to capture the market's pricing mistakes.

What makes dividend-paying stocks so flexible for investors is that very dividend itself: a seemingly small payment that can add up over time to create incredible wealth. Those dividends give you back control over a bit of your money without giving up your sliver of the businesses that generated them. And that's what makes all the difference.

What you can do with your dividends
Generally speaking, you have three broad options for what to do with your payments. You can:

  • Reinvest them in the same company that generated them, thus improving your portfolio's growth potential;
  • Spend them to cover your costs of living, thus using those payments as income; or
  • Hold on to them and wait for the market to provide you with an opportunity to take advantage. While no guarantee, having cash around does improve your chances of hitting one of Warren Buffett's famous fat pitches.

Which option or options you choose depends on where you are in your lifecycle as an investor as well as the particular stocks you own. For instance, if you're in retirement and looking for your portfolio to cover your costs of living, you'll be more inclined to want to spend those dividends. On the other hand, if you're more interested in long-term growth, one of the other two options may seem more appealing.

Look for opportunities
Mortgage real estate investment trusts like Hatteras Financial (NYSE: HTS  ) may be ideal for an opportunity-seeking dividend investor. To maintain their REIT status, they're required by law to pay out 90% or more of their income to shareholders, which often translates to high yields. Yet as heavily leveraged companies, their income and dividends have a tendency to vary widely during different market environments.

Income volatility often leads to stock price volatility, and stock price volatility is precisely what provides opportunities. So even if you'd like to reinvest those often generous mortgage REIT dividends in the companies that provided them, you might want to consider letting the cash pile up until the next earnings reduction takes those shares down with them. At that point, you'd have an even bigger pile of cash to buy even more shares of the lower-priced stocks.

Automatically reinvest
On the flip side, if you're looking to reinvest your dividends to grow your invested capital base, many companies offer free or low-fee dividend reinvestment plans that'll do the work for you. Looking beyond those plans, there are a handful of unique companies that will give you an equivalent impact as an automatic dividend reinvestment. They're stocks that pay their dividends as additional shares of stock instead of cash.

There are a few in the energy pipeline business, such as Kinder Morgan Management (NYSE: KMR  ) and Enbridge Energy Management (NYSE: EEQ  ) , that fit the bill. By paying their dividends as shares, they avoid many of the tax headaches of the partnerships they shadow. Still, the strategy only makes sense if there are real earnings to back up those dividends.

Those two securities are the counterparts of Kinder Morgan Energy Partners (NYSE: KMP  ) and Enbridge Energy Partners (NYSE: EEP  ) , respectively, which do generate cold, hard cash. Those two energy partnerships are a couple of the largest pipeline owners in the country, and they transport the oil and natural gas that heats our homes and powers our cars.

Take care of yourself and your family
Of course, one of the more traditional uses for dividends is to provide spending cash. Somewhat stodgy utilities like Duke Energy (NYSE: DUK  ) were once known as "widows and orphans" stocks for their steady dividends and decent yields. With its generous but still-covered 5.2% yield and its slowly but surely rising dividend since it spun off its natural gas business as Spectra Energy (NYSE: SE  ) , Duke Energy seems to still fit the profile.

There's certainly something to be said for a better than 5% yield on a dividend that has potential to grow over time, during a period when even 30-year Treasury bonds are paying less. If nothing else, it's certainly a reminder that in this still low interest rate environment, the old cliche that "stocks are for growth and bonds are for income" isn't really all that valid.

Whether you spend them, reinvest them, or hold on to them for better opportunities, you have to appreciate the flexibility that dividends bring to your investments. It's a wonderful bit of control you can get over your finances -- and one that pays well, too.

At the time of publication, Fool contributor Chuck Saletta owned shares of Kinder Morgan Management and his wife owned shares of Duke Energy and Spectra Energy. Motley Fool newsletter services have recommended buying shares of Spectra Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (16)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 06, 2011, at 6:17 PM, hondodog wrote:

    <i>Those dividends give you back control over a bit of your money without giving up your sliver of the businesses that generated them. And that's what makes all the difference.</i>

    dividend paying stocks are like seed corn to a farmer. there is always a new crop (cash dividend) for harvesting, so long as you don't eat your seed corn (stock shares)

  • Report this Comment On July 06, 2011, at 6:36 PM, surfgeezer wrote:

    Agree with hondodog and would add the MLP's are unique in the Return of Capitol that the dividends are called is not imediately taxable. It deducts from the cost basis, so no tax until sold. Effectively, no tax if passed on thru inheritance. A way for retiree's to effectively eat the cake, while passing to heirs.

    My mREIT is AGNC, and it takes a strong understanding of macro forces to invest in mREIT's.

  • Report this Comment On July 09, 2011, at 3:40 AM, mm5525 wrote:

    I own several energy MLPs (PAA, CHKM, PAA, EPB, EBD, MMP, HEP). Not only are they stable and boring, what I like about them most is the double-whammy effect provided by reinvesting the distributions into a @ a dozen more shares every quarter commission free, thusly creating a higher payout next quarter like any other stock, but then also the fact most of the MLPs raise their distributions by a penny or two every single quarter. So the next distribution is a lot higher in a two-fold way. This income stream is already growing very fast. I plan to reinvest for another 7-10 years and then use the income.

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