Dividend Investing for Dummies

 

This is the first guest blog post I have ever written and I dedicated it to Robert and his followers at Real Money Robert, whom I consider to be a fellow Personal Finance (PF) blogger friend.

I stumbled across his blog very randomly on Twitter one day. I’ve never met him but I was captivated by the vast amount of experience he has already confronted in a rather short period of time. I thought he must have a really interesting story to tell so I simply reached out to him and… 

The rest is history. We simply connected.

I picked “dividend investing” as a topic because it’s an area that I am knowledgeable about and something that interested Robert. I hope you enjoy the piece and once again, thank you Robert for this wonderful opportunity.

Happy reading!

Dividend Investing for Dummies

What Could You Learn From My Experience?

 

The idea of dividend investing can be very tempting for investors: you buy a quality stock, sit back and every quarter a steady cheque will arrive into your brokerage account entailing a % of the company’s profit, all without you having to lift a finger.

I personally love dividends because it is the most passive form of income in my side hustling portfolio:

  • Rental: I still need to do some work, usually quarterly visit, maintenance and tenancy changeover.
  • Consulting: definitely trading time for money.
  • Blog: even with high visitor volume (not there yet!) I need to release fresh content to keep the audience engaged, before even contemplating monetization.
  • Dividend: there is literally zero effort required if my initial research was sufficiently thorough. Currently, $300-400 of dividend income gets credited to my brokerage account every month without me having to lift a finger.

Here I will tell you my experience and strategy to generate a stable and consistent dividend portfolio.

What is a dividend?

A dividend is a portion of a company’s profit paid out to shareholders usually in the form of cash.

When companies make cash profit, they can usually do 3 things with it:

  1. Retain the profit for future use (usually in investment activities). For example, an engineering firm might want to upgrade its machinery to enhance productivity.
  2. Buyback share from willing shareholders (often at a premium) to reduce the total number of shares outstanding, thus boosting the stock price for the remaining shareholders.
  3. Distribute them to shareholders in the form of dividend

In reality, companies tend to do a mixture of these actions, with #1 and #3 being the most common.

How to start dividend investing?

The short answer is to buy some dividend paying shares.

The long answer actually morphs into 2 questions:

  1. What’s your available capital?
  2. How much effort are you willing to put into researching individual stocks?

If you have less than $50,000 and/or unwilling to spend at least 2 hours on an individual stock

Then I wouldn’t suggest you buying individual dividend stocks, but instead invest in some high yield index funds.

Why? 2 reasons.

1. Diversification: everybody knows that diversification is normally a positive action to take. It helps to reduce your portfolio volatility and reduces the chance of permanent capital loss. If you invested all of your capital in BP and in comes the clean-tech revolution then you are a bit screwed, whereas if you invested BP and SolarCity then you are only 50% screwed to put it crudely.

I think having around 10 stocks spanning across different sectors in your portfolio is a good number (I stick with the “picking the industry leader” route). It should be wide enough to offer the benefit of diversification but small enough to allow you to keep track of the intricacies if each company.

The problem with having less than $50,000 initial capital is that the transaction cost of buying these 10 stocks will eat up a disproportionately large part of the capital:

  • Assume each stock costs $10 to purchase, so the total cost of a transaction is $100.
  • At the $50,000 capital level, this represents 0.2% of your portfolio
  • Whereas at $10,000, this shoots up to 1%

The effect of that 0.8% gap can run into thousands of dollars once compounded over the years. Consequently, any transaction costs over 0.2% are too high for me and I would simply find a discount fund supermarket and buy an index fund, usually for free.

2. Know what you are doing: as you will see shortly, finding a good dividend stock (some even go as far as calling it a dividend aristocrat) takes time, skills and patience. For each stock in my portfolio, I usually would have already devoted at least 3 hours researching its strategic landscape, management competency, financial performance, and valuation. I actually consider this to be the bare minimum and ideally I would like to spend more time.

The rationale behind the research is to allow me to become a more informed buyer. Think of your car purchase, you wouldn’t walk into a dealership and just buy what’s on offer. Normally you’d be informed of the features and limitations of each model as well as the costing and financing arrangements prior to signing your name away. Why should you exercise less prudence with your money?

If you aren’t willing or unable to put in the effort, fear not. Just buy a dividend index fund.

They are a collection of companies that form a stock market index which the market agrees to deliver above-average dividend returns to its shareholders. Since it’s in an index that rarely changes, the cost of holding it is very low because it requires little active management.

Here’s a list that I think offers good value for money from a cost of holding point of view, alongside with their yield (i.e. the % of invested capital you will receive as income per year based on their last 12-month performance).

If you have more than $50,000 and are willing to spend at least 2 hours on an individual stock

This is where things get interesting because you can now afford to choose and pick individual stocks based on your own preference. A thoroughly researched and actively managed portfolio has the potential to significantly outperform the benchmark return delivered by index funds, as evidenced by Warren Buffett’s Berkshire Hathaway where a compounded annual growth rate (CAGR) of 19% was delivered for to its proud shareholders the past 30 years.

I belong in this category as I enjoy the process of screening, researching and selecting dividend stocks to deploy my capital. I normally ask myself the following 4 questions before investing a penny:

  1. Does the company offer an attractive yield? 2.5% is the minimum threshold for me.
  2. Does the company have 5 years or more of consistently growing its dividend?
  3. Is the company being traded at an attractive valuation? Normally a Price-To-Earning ratio of 15 or below.
  4. Does the company have a strategic advantage over its competitors?

#4 is actually the most difficult to answer as the others are very formulaic, whereas there are so many components constituting “strategic advantage”. I actually break it down into several quantifiable attributes:

  • Does it have an increasing free cash flow?
  • Does it have a rising revenue?
  • Does it have a rising profitability?
  • Does it command pricing power in the market through brand and technology that could lead to pricing premium?

Once I’ve managed to find the answers to these questions as best I could, the “investability” of a company would become abundantly clear. If I like what I’m seeing then I would simply decide on the capital allocation (minimum $10,000, maximum $50,000) and buy.

Occasionally I may drip feed during the investment process to achieve better dollar-average costing if I think there might be room for further devaluation in the future (that is to divide you allocated capital and invest incrementally across several months).

Wrap up

So there you have it. For most folks, I would strongly recommend buying a high-dividend index fund and forget about it (a technique I call “fire and forget”, although make sure you select the Accumulation unit over Income, to ensure your hard dividends get reinvested to generate more dividends).

If however you have significant available capital and are willing to put in the hours to perform stock research and valuation then constructing a diversified personalised dividend portfolio can be extremely rewarding.

Happy dividend investing! It is literally the best form of income.