Value investing implies having a long-term mentality. The value investor does not care what the price of his stock is today, tomorrow or next week (unless they are looking to buy at cheap valuations). They are only interested in what it will be in a decade, or two years, or five years. When looking to buy and hold for such lengthy periods of time, one particular type of investing can be particularly lucrative -- income, or dividend, investing.
Of course, not all value investing involves income, and not all undervalued stocks pay dividends. Nor is every dividend stock a value stock. But in general, consistently reinvesting dividends results in a compounding effect that can significantly increase the value of your portfolio. Here’s why you might want to invest in income and how to go about picking the right stock.
Why dividends?
There are a number of reasons why an investor might choose to go down the income route. First, for over a decade we have seen central banks maintain interest rates at historically low levels and engage in a slew of credit-generating measures like quantitative easing. This glut of cheap money has severely punished savers and has made it essentially impossible to live off of the interest generated by a savings account.
This has meant that conservative individuals who used to own government bonds and interest-generating cash have to look for alternative investments that are still safe, but offer a steady income -- dividend stocks. It’s anyone’s guess where interest rates will go in the near future, so this state of affairs is likely set to continue.
Second, dividend investing offers more long-term stability than many other forms of investment. Barring some major catastrophe, shares of Coca-Cola (KO, Financial) will continue to generate dividend income. By contrast, the likelihood of a beaten-down company recovering from a slump is far less certain. This isn’t to say that bargain hunting for hidden value plays cannot be profitable, but the risks are certainly higher.
Finally, the psychological benefit of seeing a constant stream of cash coming into your account cannot be overstated. The truth of the matter is that most retail investors cannot spend 12 hours a day maintaining their portfolio. Dividend investing allows you to take a relatively hands-off approach while still knowing that you are consistently gaining value from your investment and are building that retirement fund.
Where to look
A golden rule of long-term dividend investing is to go for solid, maybe even "boring" companies with a proven track record of paying out dividends. This means excluding glamour stocks and the ultra-growth stories of the tech world (not that those companies tend to pay dividends anyway) in favor of defensive stocks -- companies with healthy balance sheets in sectors that are less dependent on the state of the overall economy. These include: health care companies, utilities, oil & gas companies and consumer staples (like supermarkets) -- essentially anything that produces goods or services with inelastic demand.
Don’t chase high yields
Another good rule is to avoid high yields. While it can seem very tempting to jump on a stock promising a 9% return, in reality such payouts are often unsustainable as they drain capital from the business. This is obviously bad in and of itself, but it is also symptomatic of management that at best lacks long-term insight, and at worst is outright manipulating investor expectations. We have explored the ways in which dividends can provide signals to diligent investors here.
Of course, some industries have higher yields than others. The oil and gas sector in particular, and the basic materials sector in general, have some of the highest yields going, whereas health care typically has lower yields. Always do your research to figure out whether the yield promised by a company is in line with industry averages and, if it is not, whether it is sustainable.
Summary
Dividend investing has many advantages. The defensive nature of these stocks means your portfolio is unlikely to considerably decline in value even in lean times, and the regular cash payments compound nicely when reinvested -- particularly if you are a younger investor. The combination of these two factors will give you a peace of mind that will help you make more rational and objective investing decisions.
True, you are highly unlikely to see the value of your portfolio jump by 10% in one trading day. But with sharp jumps come steep falls, and steep falls are not conducive to good decision-making. In the next part of this series we will discuss some technical aspects of dividend stock valuation including why dividend growth is a better metric of future success than current dividend yield.
Disclosure: The author owns no stocks mentioned.
