If getting paid cash every quarter for sitting on your hands and holding some of today's best and most reliable businesses isn't reason enough, here are three more reasons to invest in dividend-paying stocks.
1. Rewarding owners
Owning shares of stock makes you a part owner of a company. But, unless your name is Warren Buffett, chances are management is not taking your calls when you want to offer advice on how to run the business.
With executives calling all of the day-to-day shots, there is nothing forcing them to pay you a dividend. In fact, in many cases it is in their best interest to hoard the company's cash. Therefore, paying out a portion of earnings to shareholders is a sign of good faith, or evidence that management is looking out for your interests.
But this isn't always the case. For instance, some companies are legally obligated to distribute their earnings to shareholders. This includes popular high-yielding stocks like real estate investment trusts and business development companies, which have to distribute at least 90% of their annual taxable income in order to qualify for favorable tax treatment.
Additionally, smaller companies can often create more value for shareholders by retaining earnings and reinvesting them. And still other companies, knowing that investors often equate dividends with financial strength, may seek to game the system. For example, Lehman Brothers paid a dividend just weeks before it filed for bankruptcy in September 2008.
So, while there are certainly exceptions, in most cases dividends are good way for management to show that they are generating profits, and that they are interested in rewarding the owners of the company, the shareholders.
2. More disciplined management
In his 1994 annual letter to shareholders, Buffett suggested, "Almost by definition, a really good business generates far more money (at least after its early years) than it can use internally."
This leaves companies with a few options: Hoard cash, pay a dividend, buyback shares of stock, or make acquisitions. As Buffett went on to say, "[O]ften the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense. That's like asking your interior decorator whether you need a $50,000 rug."
In this way, a dividend can be protection against what Peter Lynch called, "diworsification." This is the idea that a company can expand too wide, and instead of being great at one or two things, it becomes mediocre at dozens. By paying out a sizable chunk of their earnings, management is often less likely to pump money into unnecessary projects and acquisitions.
3. Compounding interest
Many investors use dividends to supplement their income -- which is yet another great reasons to like dividend stocks! -- but if you don't need the cash today, you can take advantage of what Einstein called the "eighth wonder of the world." By investing in dividend-paying stocks, reinvesting the dividends back into the company, and reinvesting the reinvested dividends, your wealth snowballs, and the longer to hold on the more dramatic the effect.
The chart below shows what would have happened if you parked $1,000 in the S&P 500 in 1965, and just waited. As you'll see, reinvesting dividends makes a big difference.
Admittedly, 50 years is a long time, but the most incredible part of this chart is actually happening in shorter terms. Given soaring inflation between 1965 and 1985, your total return would have been a dismal -41%. However, by reinvesting your dividends, you would have been up 31%. Hang on another 10 years, to 1995, and the difference grew from a 12% total return to being up 247% -- again, adjusted for inflation.
But be warned, not even the magic of compounding would have saved you from an investment in Enron or Lehman Brothers. As Warren Buffett has said, "Time is the friend of the wonderful company, the enemy of the mediocre."
Ultimately, there are some great advantages to investing in great businesses, paying great-big dividends, and if you wondering where to start looking, try one of these 9 Top Dividend Stocks to Buy in 2015.
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