Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

Retirees and other investors who need to meet ongoing obligations with their savings benefit from steady inflows of cash. And investors still in accumulation mode can reinvest dividends, further nourishing the future value and earning power of their portfolios.

Dividends are typically an indication that a business is established and financially healthy enough to return cash to shareholders. Dividends also force management to be focused on the long term and disciplined with their capital allocation decisions: After a company declares a dividend, it usually tries very hard to avoid cutting the payout, even during lean times. A dividend cut is a signal that a company’s earnings are weakening, which will lead many investors to dump their shares.

Investing in Dividend-Yielders
Unfortunately, it is not always the case that the stocks yielding the most are the healthiest ones with the most cash on hand to return to shareholders. Simply choosing stocks with the highest dividend yield can often result in picking highly risky stocks that are priced low relative to their dividends, due to potential financial distress.

That is not to say that investing in companies that pay higher dividends is a bad idea. (For purposes of this article, let us define “dividend yielders” as stocks with yields higher than 2%.) But when investing in dividend yielders, your investment criteria should consider more than just the yield. In order to determine if a company can continue to pay out a high dividend yield, make sure you focus on stocks of companies that are financially healthy enough to sustain and even grow their dividend.

Investing in Dividend-Growers
Companies whose cash flows have translated into a rising payout are known as dividend-growers. These are not always among the highest-yielding securities in the market; in fact, it is important for investors to have reasonable expectations for dividend growth strategies. Investors seeking current income might not be satisfied with a yield of a dividend growth portfolio, as their yield may only be slightly higher than the market as a whole.

What is the appeal, then? Companies that are focused on growing dividends tend to be higher-quality, cash-rich businesses that hold up well in down markets, participate in up markets, and are capable of excess returns over a full market cycle. In addition to being core, defensive holdings, companies that are growing their dividends provide some protection from inflation: A rising dividend is fundamental to investors’ ability to preserve purchasing power through their equity portfolio.

It is also likely that dividend-growth stocks will be less sensitive to losses during periods of rising interest rates. For example, a high-yielding utility stock intuitively becomes a less attractive income source when yields rise on bonds, a less risky asset class. But because dividend growers tend to sport more modest yields, they were never the first choice for yield hounds in the first place.

 

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