Investing in companies that pay healthy dividends has been getting a lot of media coverage lately, especially with the short term future of the markets being difficult to predict. Personally, I have a long term view of investing in quality companies that have a solid history of paying a dividend. Below are 5 advantages of dividend investing….
Dividends provide for steady, predictable cash flow. Sure, there are other ways to generate cash flow to shareholders (such as return of capital) but dividend stocks provide predictable, consistent cash flows to patient investors. In a market that can be difficult to predict, the consistency of dividends is a large factor in the decision of many investors.
Managing Company Spending
Dividends provide a ‘check’ in company spending. Companies that have a history of paying steady dividends are most likely to manage their annual costs because they are accountable to their shareholders through the dividends. The markets punish companies who cut their dividends so it is usually done as a last resort only. Dividends influence company spending because they budget to pay the dividends through the annual budgeting process. It’s sort of like a ‘forced savings’ being placed on a company – in a good way
Dividend Reinvestment Plans (DRIP)
Many companies offer a dividend reinvestment plan (DRIP). This is basically when a company offers its shareholder the chance to receive dividends in the form of shares instead of cash. While cash is king, this may be advantageous for someone who has a long term investment focus. The shares are usually offered at a discount from their current price (sometimes 5% below the current value) as an added incentive
Companies that pay dividends usually do not face the extreme highs and lows of other stocks. When the share price of a dividend stock decreases, the yield increases, so this usually tends to create upward pressure on the stock and more of a balance than other stocks. Dividend stocks are in demand because of the cash flows they provide and tend to have lower betas (an indicator of a stock’s risk in relation to the market) so they are favored by investors who prefer to take a ‘slow and steady’ approach
Outperforming the Market
Dividend stocks tend to outperform the market over the long term. James O’Shaughnessy did a study that looked at the returns of high-yield stocks from 1951-2003. In the worst market decline over that time period large stocks went down nearly 50% but dividend stocks only decreased 29%.
Conclusion: Dividend investing is a popular strategy because it offers lower risk, long term growth with steady cash flows along the way. Dividends from Canadian companies are also taxed at a lower rate because of the dividend tax credit. Companies that pay dividends feel obligated to continue paying them (or increase them), otherwise they are usually punished by the markets. Since executive compensation is typically tied to share price, a steep decrease in the share price is not in a senior management’s best interests and therefore dividend cuts are usually a last resort.
What do you think of dividend investing as a strategy? Do you invest in companies that pay dividends?