When you think of the stock market, it's easy to imagine a singular game between buyers and sellers. But in reality, many games are simultaneously played in the same arena.
Income investing is a unique way of being involved in the stock market. Instead of using capital gains (buying a stock and selling it for a higher price) as the primary driver of returns, the focus is on income from dividends. Income investors may ignore popular stocks in favor of stodgy dividend-paying companies that return most of their earnings directly to investors.
However, income investors often make one big mistake. Here's what it is and how to avoid it.
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The objective of income investing
If you're not an income investor, you may be wondering why folks do it in the first place. After all, the average annual return of the S&P 500 is around 9% or 10%. So why buy a dividend-paying company with a 5% yield?
The primary reason is that income investors are risk-averse or focus more on capital preservation than capital appreciation. The S&P 500 has an attractive average return. But it can do just about anything in the short term.
After the financial crisis of 2008, it took the S&P 500 about six years to recover to its previous high, reached in 2007. If you had the patience and conviction to hold through that period, it was worth it. But many investors don't have the time horizon or temperament to do that. It sounds easy in hindsight. But those who have been through bear markets know how difficult it can be to see the light at the end of the tunnel when equity prices are crashing all around you.
Quality dividend stocks, like Coca-Cola or Procter & Gamble (PG -0.78%), have recession-resistant business models and tend to outperform a bear market. They also have over 60 years of consecutive dividend raises. However, they don't have the growth prospects of many smaller companies in other sectors. For that reason, they tend to underperform a strong year in the market, which is exactly what happened in 2023.
Avoid these mistakes
Unfortunately, investors can pass on quality companies and fall prey to a higher yield. A perfect recent example is what happened last week with Walgreens Boots Alliance (WBA 0.57%).
Walgreens reported its first-quarter fiscal 2024 results on Jan. 4. But all eyes were on Walgreens' 48% dividend cut.
Prior to the cut, Walgreens had a yield of around 8% -- making it one of the highest-yielding stocks in the S&P 500 and the highest-yielding stock in the Dow Jones Industrial Average. But Walgreens wasn't supporting its dividend with earnings.
The biggest mistake income investors make is looking at the size of a company's dividend or how long it's been paying the dividend, instead of looking at how the business is doing and whether it can support future dividend growth. After all, what good is a high yield if the stock's going down and the quality of the underlying business is deteriorating?
Another example is Costco Wholesale (COST 1.01%). Unlike Walgreens, Costco has been a market darling stock -- a true outperformer and an industry leader. But Costco has a bizarre dividend program. It pays a relatively small ordinary dividend. Then, every few years, once it accumulates enough cash on the balance sheet, it pays an unusually large one-time special dividend.
Costco recently announced a $15 per share special dividend. The special dividend "feels" great, certainly better than a regularly scheduled ordinary dividend. But it doesn't happen all the time, it isn't guaranteed, and it's uncertain how large it will be.
In fact, even when factoring in the special dividend, Costco won't even yield as much as Target in 2024.
Again, we have an example of an income opportunity that sounds great at first glance. But in reality, it's a bit misleading.
Income investing centers around predictability and is often a way to supplement income in retirement. An unsustainable high yield (Walgreens) or a company that sometimes pays special dividends (Costco) misses that objective.
Income investing done right
Before approaching a potential income stock, you'll first want to make sure that the business itself is one worth owning. Next, you'll want to look at metrics like the payout ratio, which is the amount of earnings that are being used to pay the dividend. Look at free cash flow, and whether it's high enough to support the dividend.
After that, consider whether there are other ways a company returns value to shareholders. In the case of Apple (AAPL -0.35%), the dividend yield is only 0.5%. But that's because Apple doesn't focus solely on dividend raises. Instead, it's famous for supporting a massive stock repurchase program, which helps reduce the outstanding share count and makes the stock a better value over time.
Extremely risk-averse, income-oriented investors may prefer a company that doesn't do any buybacks and focuses solely on the dividend. There are companies that do that, like pipeline giant Kinder Morgan and its sizable 6.4% yield.
But folks who are OK with a lower yield and more investment in the business and the benefits of buybacks may prefer a company like Procter & Gamble, which consistently increases its dividend, buys back a ton of its stock, and has a strong underlying business.
Target quality over quantity
When investing in the stock market, it's important to remember that a dividend yield isn't the same as a bond's yield or the return from a risk-free asset like a certificate of deposit. A company is paying that dividend, and the ability to support the dividend is only as good as the company's fundamentals.
Over the short term, you could collect more dividend income from a riskier, higher-yielding stock. But this strategy has holes and can collapse in a heartbeat, as we saw with Walgreens.
By approaching an investment as a business first and considering the yield second, you can help avoid the misleading allure of high-yield income stocks and likely make a higher return over time.
