This simple income technique is versatile enough to be the cornerstone for both conservative and more growth-oriented strategies.
And powerful enough that it has been used to build some of the largest fortunes in history. (It was John D. Rockefeller’s most lucrative income play.)
Ron and Bro will show you how you use this simple strategy to generate income in your portfolio. Plus, Ron will reveal one of his favorite stocks that you can buy TODAY to start putting this strategy in action.
View the transcript of this video.
Total Income Special Report: Dividends
We all invest for different reasons, but for many of us the general themes are the same: education, house purchase, retirement, etc. At some point in our lives we may seek to generate income from our portfolios. Specific to the stock portion of our portfolio there are two basic methods we can use to put cash into our pockets: invest in dividend paying stocks and/or liquidate a portion of our portfolio. It’s likely that when you’re in retirement you’ll need a combination of both of those methods. For now, though, let’s focus on good old dividends.
Some Dividend Basics
To start, remember that (theoretically) a company's value is the current value of its future cash flows, plus any excess cash on its balance sheet. Also, recall that when a company makes money, it has a few choices about how to use it: It can reinvest back into the business, hold onto the cash, return the cash to shareholders via dividends, or buy back its shares.
When a company chooses to pays a dividend, it's like a transfer of wealth. What was previously an asset of the company now belongs to shareholders. For that reason, the company's value declines, if only temporarily. It's no longer in possession of that cash.
So although it's tempting to think that when we receive a dividend, we've "made" money, that's not exactly right. Instead, this is like water changing form, from snow to rain. Management has returned an asset of the company to you instead of holding it, and for that reason, the value of the company has declined.
For those investors that seek a steady stream of income, receiving a dividend might be exactly what you want. But, it’s interesting to think about one more complicated aspect of a company’s cash management process. If a company believes it has solid future growth prospects then as a shareholder of that company you might prefer that management holds onto its cash and reinvests it in the business. This should lead to earnings growth and a higher stock price in the future. That could in turn lead to more “income” when you decide to sell that stock. You could, in a sense, "create" dividends by selling some of your stock. Or, if you decide to hang onto the stock, perhaps the now more valuable company will pay out a higher dividend when it finally decides that its growth prospects have diminished and it no longer needs to hoard all of it its cash.
When we think about investing in dividend stocks for a stream of income, let’s make sure not lose sight of the concept of Total Return: Dividend Yield + Stock Price Appreciation. As a shareholder you should want the highest total return possible. To this end, you should also want the management teams of your companies to make the appropriate capital allocation decisions that will provide you with the greatest value creation. That decision will depend on what growth prospects the company sees ahead and how much cash they’ll need to pursue that growth.
What’s So Good About Dividend Paying Companies?
According to a study by Morningstar, “dividend-paying stocks have historically outperformed the market. Between 1927 and 2014, stocks that pay a dividend have beaten the total market by about 0.7 percentage points annualized. Stocks in the highest-yielding 30% of the market have done even better, outperforming by about 1.5 percentage points annualized.” What is it about companies that pay a dividend that have led them to outperform the market across time? Should that be the case if dividends are just a transfer of wealth from company to shareholder?
To start, companies that pay dividends for the right reason should generally be high-quality. The simple fact that they can even pay a dividend is a vote of confidence in their future cash-generating capacity. (If there's any concern about the future, they should be hoarding cash or frantically attempting to reinvent themselves.) But even more important is the discipline that dividend payments impose on companies.
A great deal of research shows that management teams are, well, human and subject to the same behavioral follies as the rest of us. In Chris Zook’s book, Profit from the Core, he found that only 13% of companies (in a sample of 1,800) were able to sustain real—net of inflation, that is—revenue and profit growth across the 10-year period between 1997 and 2007. But, management teams still try to build castles to the sky. They pursue ill-advised growth strategies. And they waste shareholders' money. But management teams that pay dividends for the right reasons are acknowledging their humanity. Dividends provide a check and balance, of sorts.
In the very practical sense, dividends tell you one of two things. In option one: Management does not see intelligent use for the company's cash, so instead of investing in that apparently promising gorilla-suit business, the company has opted to return the cash to you. Or in option two: The company is imposing discipline on itself. Paying cash out as dividends limits the amount it can invest. Managers must prioritize. The probability of ill-advised projects seeing the light of day is reduced. Either way, dividends are a sign of savvy, self-aware capital allocation. They clarify, prioritize, and force discipline. And, they enable dividend investments to deliver on three promises with relative stability: growing income, wealth preservation, and capital appreciation.
Show Me the Money
Now that we’ve discussed some of the more theoretical aspects of dividends, let me show you the money. At Total Income we’ll be making you aware of dividends that come in many shapes and sizes. Our proprietary filter will scour the Motley Fool universe of dividend stocks to bring you the best ideas at any given point in time. To help organize and understand them, we’ll be placing Total Income’s dividend-paying companies into one of three categories: High Yield, Dividend Growth, and Low-Risk Dividend.
Companies that fall into our High Yield category will have a dividend yield that is significantly greater than your typical dividend paying company. At the moment, the S&P 500 has an average dividend yield of about 2.0%. Total Income’s High Yielders will have yields significantly higher than the S&P. But, because we’re always thinking about wealth preservation, capital appreciation, and total return (see above), we’ll make sure that our analysts think these companies are high quality too. Sometimes an exceptionally high yield can be a red flag, so we’ll always be on the lookout for potential pitfalls that could take a bite out of your principle.
Some companies have shown the ability to increase their dividends consistently over time. These companies may already have sizable yields or they may have small but growing dividends. Owning companies that will consistently grow their dividends is a great way to increase that income that you’re putting in your pocket each year.
The most well know dividend growers belong to an elite group known as the Dividend Aristocrats. These are companies within the S&P 500 index that have increased their dividends every year for the last 25 years. And, there’s more to these companies then just dividend growth. Remember, always remember, total return. The S&P Dividend Aristocrats Index has outperformed the S&P 500 over the past decade. According to S&P, Dividend Aristocrats generated an annualized return of 9.7% over the past 10 years, nicely beating the market’s 6.3% return. Interestingly, during this period, dividends accounted for 31% of the market’s total return, which is an important reminder that dividends do play a significant role in total return.
Low-Risk Dividend Stocks
Speaking once again, yes, about total return, it makes sense for shareholders to want their stocks to appreciate or, at the very least, to not go down. Earning a 4% yield while your stock declines in value isn’t something to cheer about. Stocks that pay a nice dividend but also have less volatile stock prices will fall into our Low Risk category. Now, this doesn’t mean that companies in this category are without risk and that their dividends are completely safe. All stocks have risk. But, these companies have demonstrated that their stock prices are stable relative to the market as a whole.
One Great Dividend Growth Stock to Consider Today
One of the favorite stocks in the Motley Fool universe at this very moment is Starbucks (Nasdaq: SBUX). Starbucks fits very nicely into our Dividend Growth category here at Total Income. As you are probably aware, the company has been growing rapidly over the years. It seems like there’s a Starbucks on every corner at this point. Yet, the company still has plenty of room to grow, especially overseas. From a dividend perspective, the company generates plenty of cash flow to sustainably pay what is currently a 1.8% yield. Now that might not be a yield that knocks your socks off but think of this: since the company started paying a dividend back in 2011 it has consistently, year after year, grown that dividend in excess of 20% annually. That’s the kind of growth that adds up over time and puts more money into your pocket each year. Plus, the stock performance hasn’t been too shabby either. In fact, over the last five years, shares of Starbucks has increased about 130%, crushing the S&P 500's 72% appreciation.
Time for Some Caution
We’ve now come to the part of our story where I feel compelled to tell you that everything isn’t always peaches and cream. There are times when, for various reasons, dividend stocks will have increased in value to a point where the stocks as a general category should be considered fairly-valued or even over-valued. Alas, as a result of the low interest rate environment we’ve been living with for many years, now (February 2017) should be considered one of those times. According to work by Rob Arnott and Research Affiliates, the pioneers of smart beta, dividend stocks are more expensive than 80% of other periods across the last 40 years.
So, what’s a Fool to do about it you ask? This is where careful stock picking becomes increasingly important. Rest assured that we will introduce you to specific dividend paying companies with our eyes wide open. We will not be wearing dividend blinders as we pass along investment ideas to you. We won’t be chasing yield when it will put your principle at risk. Rather, we will only focus on dividend paying companies that are considered by our Foolish analysts to be exceptional investment opportunities right now.
The Foolish Bottom Line
We’re big fans of dividend paying companies at the Fool. We believe that dividends clarify, prioritize, and force discipline on management teams and that companies that pay dividends are typically of high-quality. Furthermore, we recognize that dividend yields are a meaningful portion of a stock’s total return. That’s great news for those investors that seek to generate sustainable and increasing income from their portfolios.
We look forward to embarking on this dividend journey together. Fool on!
Motley Fool data as of February 9, 2017