Building Income With Dividends

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Happy Wealth Wednesday! In this newsletter, we will discuss how to build wealth with dividends.

Here’s What You Missed Last Week:  

1. The Bean Breakdown

2. Top 5 FinTech Stocks To Own

3. Build Wealth With Moats

Dear friends,

I get a lot of questions from people about building a dividend portfolio, so I thought I'd share some insights to help you out. Feel free to add these notes to your investment playbook.

My Take on Dividend Portfolios

I believe you need a substantial amount of capital to make a dividend portfolio worthwhile. When you’re just starting out, your money might be better spent elsewhere. That said, plenty of smart investors completely disagree with me, so make sure you find what works best for your goals.

One thing worth noting: “Old Warren Buffett” loves dividend stocks, but “Young Warren Buffett” was all about growth. In his younger years, he focused on maximizing returns, taking on opportunities that offered higher growth potential. Later in life, he shifted towards stability and consistent income, finding comfort in the reliable cash flow of dividend stocks. This transition shows how your investment strategy can evolve as your financial goals change over time.

The Dividend Stock Universe

Dividends are a share of a company’s profits paid back to shareholders. Dividend stocks, therefore, represent companies that are committed to regularly paying out these profits. Payments can be made monthly, quarterly, or even once a year, depending on the company’s policy.

The main allure of dividend stocks is the potential for passive income. Unlike relying solely on stock price appreciation, dividends offer a way to earn money even during periods when the market is flat or declining. This steady stream of cash can be especially appealing for retirees or those seeking a more conservative approach to investing.

Why Dividend Stocks?

Dividend investing comes with two main benefits.

1. Regular Income: The consistent cash flow from dividends can be reinvested back into the market or used to cover expenses, creating a reliable income stream. Think of it as a paycheck from the companies you own. This can be particularly helpful in providing income during retirement or in supplementing other income streams.

2. Potential for Capital Appreciation: While receiving dividends, the stock’s price can rise over time. This dual return—income from dividends and potential growth in stock value—makes dividend investing an attractive option. For example, a company like Johnson & Johnson not only pays out consistent dividends but has also seen steady growth in its stock price over the years, allowing investors to benefit from both aspects.

Identifying High-Quality Dividend Stocks

Not all dividend stocks are created equal. Investors often look for companies that can sustain their payouts and continue to grow them. One popular class is ‘Dividend Aristocrats’—companies that have consistently increased their dividend payouts for 25+ years. Examples include Procter & Gamble, Johnson & Johnson, and Coca-Cola. Their long history of paying and raising dividends demonstrates their financial stability and strong business models, making them attractive to those seeking consistent returns.

However, don't be lured by the promise of high yields alone. A company offering a 10% dividend might seem appealing, but high yields can sometimes indicate trouble. It’s crucial to understand the factors behind the yield. Is the company’s stock price declining, making the yield seem artificially high? Is the company struggling to maintain its payout?

For instance, a company with a 60% payout ratio (meaning it pays out 60% of its earnings as dividends) might seem healthy. It retains 40% of its earnings to reinvest back into the business. But if the industry average is a 30% payout ratio, this could indicate that the company is stretching itself thin by paying too much in dividends, potentially sacrificing long-term growth.

Key Metrics to Consider

When evaluating dividend stocks, here are some key metrics to keep an eye on:

• Dividend Yield: This is the annual dividend payout as a percentage of the stock price. A higher yield isn’t always better, as it can sometimes signal risk.

• Payout Ratio: This measures the portion of earnings paid out as dividends. A lower payout ratio suggests the company has room to continue paying or increasing dividends.

• Dividend Growth Rate: How consistently has the company increased its dividend? A track record of increasing dividends can signal financial strength.

• Free Cash Flow (FCF): This is the cash available after capital expenditures. It’s essential for paying dividends, and a healthy FCF can indicate a company’s ability to sustain its payouts.

Diversification is Key

A successful dividend strategy is incomplete without diversification. Concentrating all your investments in one sector or stock type can expose you to unnecessary risks. Think of diversification as a way to spread out your risk and not put all your eggs in one basket.

By spreading your investments across different sectors, you can mitigate those risks. For example, if you invest solely in tech stocks and a market downturn similar to the dot-com crash of the early 2000s hits, your portfolio could take a big hit. But if you had spread your investments across sectors like healthcare, consumer goods, and utilities, the downturn in tech might be cushioned by stability in other areas.

Diversification is especially important in dividend investing because different sectors perform better in different market conditions. Utilities and consumer staples might thrive during economic downturns because people still need electricity, water, and basic household products. In contrast, tech stocks might perform better in booming economies. A balanced dividend portfolio could include a mix of high-growth stocks, stable blue-chip companies, and defensive sectors to smooth out returns.

That said, you might remember that I hold a different view about building wealth initially, which I've mentioned before!

The Power of Reinvesting Dividends

Dividend Reinvestment Plans (DRIPs) can significantly boost your returns. DRIPs automatically reinvest your dividends to buy more shares of the same company, compounding your returns over time.

Take McDonald’s, for example. Suppose you bought 100 shares at $300 each. If they issued a $5 per share dividend in the first year, you’d receive $500. With a DRIP, that $500 would automatically purchase about 1.67 more shares at $300 each. Over time, these reinvested dividends compound, allowing your investment to grow faster.

Let’s look at the long-term impact: if you continue to reinvest those dividends year after year, your share count will grow, which means the amount of dividends you receive also grows. This snowball effect is one of the most powerful concepts in investing and can turn a modest initial investment into a substantial portfolio over decades.

Maintaining Your Dividend Portfolio

Once you’ve built a solid dividend portfolio, it’s important to keep an eye on it. Regularly check the earnings reports and dividend policies of the companies in your portfolio. Companies can change their dividend policies based on their financial health, and you don’t want to be caught off guard.

For example, if a company like Verizon announces a dividend cut due to declining revenues, it could be a signal to reevaluate its place in your portfolio. Dividend cuts are often seen as a red flag, indicating that a company is struggling financially or needs to conserve cash.

Regularly reviewing your portfolio ensures that you stay aligned with your goals and can adjust your strategy as market conditions change.

Dividend Yield vs. Dividend Growth

Investors often debate whether to prioritize dividend yield or dividend growth. Some prefer high-yield stocks for immediate income, while others look for stocks with consistent dividend growth, which suggests stronger long-term potential.

For example, Whirlpool offers a high yield (around 7%), making it attractive for those seeking regular income. But if a company focuses solely on high yields without consistent growth, it might struggle in the long run. On the other hand, companies like Microsoft may have lower yields but offer steady dividend growth, reflecting a healthier financial position and the potential for higher future payouts.

Which one is right for you depends on your goals. If you need immediate income, high-yield stocks might suit you. But if you have a longer time horizon, a stock with consistent dividend growth could be the better choice. Think of it like a balance between short-term needs and long-term growth.

The Impact of Taxes

Taxes play a big role in dividend investing. In the U.S., qualified dividends are taxed at a lower rate than regular income, but not all dividends qualify. To be eligible for the lower rate, you need to hold the stock for at least 60 days during a specific 121-day period around the ex-dividend date.

Knowing your holding period is key to maximizing tax efficiency. It might seem like a small detail, but it can make a significant difference in your overall returns.

The Role of Dividends in a Bear Market

Dividends can be a lifesaver in a bear market, providing a buffer when stock prices drop. While the value of your portfolio might dip, those dividend payments can soften the blow. This consistent income can be reinvested to buy more shares when prices are low, setting you up for greater gains when the market recovers.

For example, let’s look at PepsiCo. If the market takes a downturn and PepsiCo's stock price drops by 10%, the dividends they continue to pay can help offset some of those losses. It’s one of the reasons why dividend stocks can be so appealing during market downturns. You’re not just relying on the stock’s recovery—you’re also getting paid along the way.

The Bean Team

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