2022 has been a brutal year for investors, as many reputable small and large companies have seen their valuations crushed by a medley of recession fears, consequences of rising interest rates, inflation, geopolitical risks, and other factors. But 2022 doesn't tell the full story of why it's been a difficult time for investors. For that, we need to go back to 2018.
There have been three bear markets in less than four years: the U.S.-China trade war that sent markets tumbling in late 2018, followed by the 2020 COVID-19-induced bear market, and then the bear market we find ourselves in now. And through it all has been the flurry of meme stock mania, cryptocurrency crashes and scandals, and busts to booms in oil and gas paired with booms to busts across the technology and consumer discretionary sectors. These trends, along with widespread volatility, have made the investing experience stressful and confusing for many folks. If your investment portfolio is down big and you're looking to get your bearings, you're not alone.
The good news is that there is a timeless investing strategy that is highly effective over the long term and particularly resilient during bear markets. Here's why investing in companies that pay stable, growing dividends naturally results in a healthier, happier portfolio that can lead to life-changing wealth over time.
Image source: Getty Images.
The benefits of income investing
Before we get into the benefits of investing in dividend-paying stocks, it's important to clarify the similarities and differences between income investing and investing in dividend stocks.
With income investing, the investment thesis is centered more around the dividend than the potential capital gains. Income investing typically involves finding companies with low growth but high dividend yields and using those dividends to supplement income in retirement or as a sizable passive income stream. A classic example would be a company like Verizon Communications (VZ 0.88%).
Verizon is an industry-leading low-growth business with a 6.8% dividend yield. However, it is a component of the Dow Jones Industrial Average (DOW) and tends to have a dirt-cheap valuation. Verizon's price-to-earnings (P/E) ratio is currently 8.3, and its 10-year median P/E ratio is only 12.8 -- well below the S&P 500 average. In sum, investors in Verizon stock are probably not actively trying to beat the S&P 500 or produce outsized gains. Rather, they are simply looking for a way to generate income from a reliable source. Verizon's track record for dividend payments, its position in the telecommunications services industry, and the stock's high yield make it a good way to do that.
The benefits of dividend investing
Dividend investing is a bit different from income investing. Instead of choosing a stock mainly for the dividend, investing in reliable dividend-paying companies naturally leads to a lower-risk portfolio. Put another way, a company with a good dividend is, by default, a good company, assuming earnings and free cash flow (FCF) are consistently growing at faster rates than the dividend. Let's circle back to the Dow for some familiar companies.
For example, Caterpillar (CAT -0.11%), Honeywell International (HON 0.38%), and Johnson & Johnson (JNJ 0.67%) are Dow components and industry-leading companies that consistently raise their dividends and produce more FCF than needed for their dividend obligations. An easy way to check this is by looking at the relationship between FCF yield and dividend yield.
CAT Free Cash Flow Yield data by YCharts.
Notice that the FCF yield for each company is consistently higher than the dividend yield. The FCF yield is simply FCF per share divided by the stock price. It's also the maximum dividend yield a company could have if it used 100% of its FCF to pay dividends. Caterpillar, Honeywell, and Johnson & Johnson are all using less than 70% of their FCF on their dividends, providing a nice margin of error in case FCF declines.
However, these three companies have far lower yields than Verizon. So the dividend yield on its own isn't enough to supplement income in retirement or produce gains that exceed the risk-free interest rate (currently 4.3%). But that's OK because there's higher growth potential from these companies. In this vein, the dividend should be viewed more as the cherry on top of a fundamentally strong company than as the core reason for buying the stock. Selecting reliable dividend stocks effectively gravitates your portfolio toward quality companies, in turn leading to lower volatility and higher confidence during bear markets and unlocking a passive income source.
The drawbacks of dividend investing
No strategy is perfect. And there are definitely some cons to dividend-paying companies. For starters, you could argue that money used to pay dividends would be better spent reinvesting in the business through organic growth or mergers and acquisitions.
It's no secret that companies that use the majority of FCF on dividends tend to grow slower than companies that don't pay dividends. And for that reason, higher-growth companies usually outperform a bull market, while safer dividend stocks can underperform a bull market. On the flip side, the reliability of dividend-paying companies can help them outperform higher-growth companies during a bear market.
A strategy suitable for everyone
Understanding dividend stocks' role in a diversified portfolio can lead to sound investment decisions. But the bigger lesson here is to realize what it takes for a company to raise its dividend steadily over time. In short, it's no easy task. A growing dividend has to coincide with growing earnings and FCF unless a company uses debt to pay the dividend. Again, looking at the FCF yield relative to the dividend yield is an easy way to ensure the dividend is being supported with FCF.
Companies with track records for growth over time while supporting a dividend are natural winners when investors are on edge. But they are also good long-term investments, even if that means underperforming higher flyers during a bull market.
Income investing appeals to risk-averse investors focused more on capital preservation than capital appreciation, and high-growth investing appeals to risk-tolerant investors focused more on capital appreciation than capital preservation. Dividend investing, however, is a more balanced approach that works for almost everyone. It's a great way to earn a bit of passive income while lowering your chances of catastrophic losses during a bear market. Now is as good a time as any to consider dollar-cost averaging into top dividend stocks.
