Follow These 3 Rules to Ensure You Don't Fall Into The Dividend Trap

Are you a dividend growth investor?

Imagine waking up to a dividend payment getting credited into your bank account. You just got paid while you were asleep. That is the beauty of dividends. There’s a saying that you can’t have your cake and eat it. Dividends can also be a double edged sword, as you will soon find out.

What are Dividends?

Investopedia defines dividends as:

A dividend is the distribution of some of a company's earnings to a class of its shareholders, as determined by the company's board of directors. Common shareholders of dividend-paying companies are typically eligible as long as they own the stock before the ex-dividend date.

Dividends may be paid out as cash or in the form of additional stock.

Why Do Companies Pay Dividends?

Companies who pay dividends tend to be big, well-established companies that have too much cash. Mature companies who have not much room for growth choose to pay out their cash as dividend instead. This contrasts with growth companies, where they reinvest their dividends to grow their business.

Why invest in dividend growth stocks?

Dividend growth stocks tend to be of higher quality than those of the broader market in terms of earnings quality and leverage. When a company is able to boost its dividend for years or even decades, this may suggest it has a certain amount of financial strength and discipline.

Many investors have the misconception that dividend stocks produce lower overall returns compared to growth stocks. While this might be true to some extent, dividend stocks can still beat the market, something which most fund managers fail to do.

This data suggests that investing in dividend stocks in regions such as Pan Asia, Japan, and Canada might provide outsized returns compared to the benchmark index.

In an uncertain environment like the one we are in now, stocks with a history of dividend growth could present a compelling investment opportunity. An allocation to companies that have sustainable and growing dividends may provide exposure to high-quality stocks and greater income over time. This helps to buffer against market volatility and addresses the risk of rising interest rates to a certain extent. Most importantly, it helps keep our emotions in check.

Should I re-invest my dividends?

Dividends, when re-invested, can significantly increase total returns over time.

Over the last 100 years (1921 to 2021), the annual return of the S&P 500:

-        With dividends reinvested: 10.7%

-        Dividends not reinvested: 6.57%

That’s a difference of more than 4% annually! This illustrates the power of the compounding of re-invested dividends.

You may think that the S&P 500 ETF only pays an annual dividend of 1% to 2%. What we fail to realise is that dividends are a large component of total S&P 500 index returns. About 40% of the annualized return was attributed to dividends over the past 100 years.

The Dark Side of Dividends

Dividends are not guaranteed. This is something that you should consider when investing in dividend stocks. Companies can stop paying dividends if necessary, or if legally required.

Market conditions like the Covid pandemic in 2020 saw some dividends either being cut or suspended. In 2020, about 68 of the 380 dividend paying companies in the S&P 500 either saw their payouts suspended or reduced. Similarly, there were dividend restrictions placed on banks and finance companies. These restrictions were taken as a pre-emptive measure during periods of uncertainty. Outside of extraordinary events like Covid-19, companies generally only cut their dividends when they are in distress.

How to Pick Good Dividend Growth Stocks?

Rule #1 Dividend Growth Over Dividend Yield

Perhaps the most important rule of all is growing dividends.

Dividend yield comprises of:

Dividend/ Price

A high yield could mean 1 of 2 things:

-        Decreasing share price

-        Increasing dividend

If the dividend remains the same but the share price keeps decreasing, the dividend yield will increase. This is not something we want.

In an ideal scenario, we want to find companies that increase their dividends consistently. If they do, the share price will follow suit. This is why you see the dividend yields of some companies remaining low. It is likely that the share price has increased at a similar or faster rate than their dividends.

Chasing high yields is a sure-fire way to lose money. A high dividend yield alone does not necessarily make a good dividend stock. If the dividend increases but the price remains the same, the dividend yield will also increase. This is something we want, but there are other factors like payout ratio which we need to monitor.

We’ll look at the S&P 500 High Yield Dividend Aristocrats and the S&P 500 High Yield Dividend Index to illustrate the concept of dividend growth and high dividend yield.

The S&P 500 High Yield Dividend Aristocrats includes companies with a history of at least 20 straight years of increasing dividends. We use this as a proxy for dividend growth stocks.

The S&P 500 High Yield Dividend Index includes companies we call high dividend payers. We use this as a proxy for high dividend yield stocks.

Exhibit 4 suggests that a significant fewer number of dividend growers cut their dividends compared to high dividend payers (7.2% vs 36.1%).

Exhibit 5 shows that dividend growers tend to perform better than high dividend payers in down markets.

Rule #2 Payout Ratio Less Than 1

The payout ratio tells us how much dividends the company is paying out of its earnings. If the ratio is more than 1 or 100%, this could be a sign that the dividend payout is not sustainable. If the company is earning $1 per share but it is paying you $1.20 per share in dividends, this dividend is going to be cut eventually.

Rule #3 Low Debt

Most global securities laws mandates that a company must pay its creditors before paying dividends. If the company has high levels of debt, chances are they are taking out debt to pay your dividends.

Tax Drag and Fund Fees

Depending on the country you reside in, you might need to pay taxes on your dividends. This will reduce your total returns. Let’s call this the tax drag (i.e. tax dragging on your returns).

This tax drag depends on 2 factors:

-        Dividend tax rate

-        Dividend yield

Consider an investor named Tom. Tom pays 30% tax on dividends. He holds the S&P500 ETF that provides a 1.5% dividend yield.

Tom will have an overall dividend tax drag of: 30%*1.5%=0.45%. This means that his total returns will be 0.45% lower than the total S&P500 ETF (SPY) returns.

There are also fund fees that add additional drag on your returns. The total drag including fund fees can be found by adding the management expense ratio (MER) to the dividend tax drag.   

SPY has an expense ratio of just 0.095% annually. The total drag on returns will be (30%*1.5%) + 0.095% = 0.545%. Tom’s returns of holding SPY will be 0.545% lower than the total S&P 500 ETF (SPY) return.

This 0.545% fee is significantly lower than mutual fund fees of 1 to 2.5%.

2 Dividend Paying Vehicles

In my opinion, there are 2 main vehicles you can invest in for dividends:

1) Stocks

Good old dividend paying stocks. Stocks that pay dividends tend to be mature companies that have no use for their cash.

2) REITs

The real estate investment trust (REITs) asset class is another vehicle to explore. They are engaged in the business of real estate. REITs are legally required to pay out a minimum of 90% of their profits to shareholders, in exchange for being exempted from paying tax.

Takeaways

If you only took 1 thing out of this, remember that dividend growers are better than high dividend payers.

The sustainability of a company’s dividends depends on its:

• Payout ratio

• Debt levels

What’s attractive about dividend growers compared to high dividend payers:

• Lower drawdowns during market downturns.

• Less risk of facing dividend cuts.

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