Dividend stocks: Consistent cash flow or ticking time bomb?
Here's what you need to know before you invest.
Everyone loves dividends.
Cash that comes in without us lifting a finger always feels great.
It’s one reason why many investors are attracted to high dividend yields.
A prime example in the crypto space is Anchor protocol, offering yields of 20%.
It was the perfect bait, offering the promise of “early retirement”.
At a 20% yield, you could earn $20,000 for every $100,000 of capital.
Little wonder that more than 250,000 people got lured in, losing their hard earned savings.
Though I was not affected by this incident, a similar thing happened to me in my earlier investing years.
In the same vein, I invested in xxx stock because I knew it was about to pay a huge dividend (also about 20% from memory).
Shortly after the dividend was paid, the stock price dropped by more than half.
In the end, the dividend that I received was not enough to make up for the capital loss. I admitted my mistake, sold the stock, and took the losses.
Lesson learned: look beyond the dividend yield. Don’t be tempted by huge yields.
U.S stock market for dividends?
In a recent market study conducted by Scott Ospal, director of research the Leuthold Group, the performance disparity between dividend payers and non-payers can be attributed to the large size of companies not paying dividends.
The table shows data of returns from dividend, non-dividend payers, and the entire group from January 1990 to Sept 2020.
Evidence suggests that dividend paying stocks out-performed non-dividend payers for small and mid-cap stocks during this 30-year timeframe.
The problem is: small and mid-cap stocks tend to be obscure and not widely covered. It’s like finding a needle in a haystack.
Since I don’t like to play in fields where I don’t have an edge in, I prefer to look elsewhere.
Closer to home.
Why I prefer the SG market for dividends
As a Singapore investor, however, I prefer to look to the Singapore stock market (SGX) for dividends.
While the growth in the SG stock market is slow and non-existent at times, there’re 2 reasons why I personally feel that it’s the best place for dividends.
Not taxable
Why I like investing for dividends in such a sluggish Singapore stock market (SGX) is because dividends are non-taxable.
In comparison, investors from SG investing for dividends in the U.S would be subject to a 30% withholding tax.
Given the already low yields of 1% to 3% for majority of U.S listed companies, it’s not worth the effort for me.
Decent dividend yields
Many stocks on the SGX has attractive dividend yields, where a 5% yield is commonplace.
But don’t let dividend yield be the main factor in stock selection.
As we already know, excessively high dividends can be a red flag.
An excessively high yield could be a signal of a company’s deteriorating fundamentals.
The fall in stock price of a fundamentally weak company will drive up the dividend yield.
Looking beyond the dividend yield
Many new investors make the mistake of looking at the dividend yield when investing for dividends.
This is the most dangerous thing you can do as an investor.
Instead, look for dividend growth over dividend yield.
Don’t get sucked in by juicy dividend yields, only to be stuck with a huge capital loss.
Let’s say you are buying a stock with a 3% dividend yield, and the company raises their dividend every year by 10%.
In Year 2, you’ll be getting a 3.3% yield.
In Year 3, you’re looking at a 3.63% yield.
Eventually, if you hold the stock long enough (and provided it’s a good one), your yield is only going to increase.
An example is the company below, where the dividend has more than doubled over time.
This company always has a history of having low dividend yields, sometimes even lower than risk-free rates.
While this may put off some investors, it’s exactly the kind of company that we’re looking for when investing for dividends.
Conclusion
Dividends form an important role in an investor’s total returns. But not all dividend paying stocks are created equal.
There’s even an argument for dividends as a form of mental wellness.
Many fall into the trap of being enticed by the dividend yields. Look at the dividend growth instead.
The longer the track record of dividend growth the company has, the better.
Beyond dividend growth, there are 2 other factors to watch out for:
Payout ratio
Debt
Payout ratio tells us how much (normally expressed as a %) of net income that a company pays out as dividends to shareholders.
Anything below 100% (or 1) is acceptable, the lower the better.
A company that is taking on debt just to pay dividends is a red flag.
It’s only a matter of time before a debt-ridden company collapses.
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