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Dividends- the next best thing after sliced bread?

Updated: Apr 13, 2020

Let's talk about dividends.

For the uninitiated, dividend is a distribution of rewards/profits from the company to the owners of the company's stock aka the shareholders. It could be given either in the form of additional stocks, or cash. Sometimes, this option is given to you as a shareholder. Sometimes, it's not. Most of the times, dividends are given at specific regular intervals (eg. every quarter/half-yearly etc). To the shareholders, dividends represent a source of passive income which they could get by simply doing nothing but investing in the company. This works well for passive income investors like me who aims to build a passive income to ultimately match my active income.

So who pay dividends? Do all companies pay dividends?

No, not all companies pay dividends. Simply because it's not sustainable for all companies. Paying dividends means that the company need to distribute a portion of the profits back to the shareholders. Now, such model will not work for growth companies. For growth companies, the priority is to constantly reinvest its profits back into its operations or new revenue generating streams in order to build up its market share. If a growth company is to provide dividends, they will be slowed down and that contradicts what a growth company should be doing. Hence, dividends are usually paid by stable mature companies who are no longer in the initial stages of growth and will not be experience the same rate of growth as the growth companies. For these companies, their objective has now changed to increasing value for their shareholders by providing them dividends.

This is also why there has been a constant debate on which type of company is best for investing? Is it a growth company or a company that pays regular dividends? Well, hold your horses there. I will show you statistically which suits you better in the later part of this article.

But first, let's continue to dive a bit deeper into dividends. While most people are familiar with dividend yield which is simply dividing the dividends over the share price, few are familiar with the term payout ratio (which is another key aspect of dividend). Payout ratio is derived from dividing total dividends over the net income. Why is this important? This is simply because you want to know how much of the net income is the company redistributing to the shareholders as dividends. If the ratio is too high, this isn't going to be good for the company as it means that it has little income left to reinvest in itself and hence future growth is expected to be stagnated. If the ratio is too low, it might also mean that the company is not placing a high priority on increasing value for its shareholder and this might deter some investors.

How do you then determine what's a right ratio then? A common method will be to compare the payout ratio of a company with its other competitors in the same industry. Payout ratios are usually very industry specific. For instance, REITs will have to pay out 90% of their net income as dividends. Hence, every industry has its own practice and a quick way to look for abnormalities is to simply compare a company's payout ratio against its peers.

Now that you understand more on dividend yield and payout ratio, we could better appreciate the quadrant as shown below (as a general guideline)

Generally, you will want to identify stocks which have high dividend yield and low payout ratio (which is a Golden Star). A low payout ratio will ensure that the safety of dividend payout. There is no point if a company promised to pay you high dividend yield but you know that it is spending almost all of its net income on the dividends. An example of companies that fit into this "Golden Star" criteria right now is China Telecom. Bear in mind though that we are not assessing any other fundamental metrics such as P/E, P/B or even the future growth of the company here. We are simply assessing the companies based on the dividend yield and payout ratio.

Similarly, a stock with a low dividend yield but a high payout ratio should be avoided like a plague based on the same logic. Thankfully, I don't think most dividend stocks will not fall under this category.

So, back to the topic earlier on. Is it worthwhile to invest in dividend paying stocks as compared to the other non-dividend paying stocks like growth stocks?

Well, apparently the answer is yes. In the research done by J.P. Morgan in 2013, dividend paying stocks within S&P 500 have a better long-term return with lower volatility as compared to the other non-dividend paying stocks within S&P 500. From 1972 to 2012, stocks of companies which grew its dividends have an annualised return of 9.5%. In the same time period, stocks of companies which maintain its dividends have an annualised return of 7.2%. And guess what? Non-dividend paying stocks have a mere annualised return of 1.6%. This outperformance by dividend paying stocks against non-dividend paying stocks also holds true in shorter time periods (eg. 10 years period, 3 years period etc) according to the research.

Hence, I do think that the statistics shown here is sufficient to convince that dividends is an important consideration for returns from equities and the focus should not be purely on capital appreciation.

A few weeks ago, I wrote an article on "Can you retire at age 40?- from a data science perspective". In the article, it was highlighted that a high annualised rate of return with low volatility is key in ensuring you are well prepared for your retirement plans. From a statistical point of view (as illustrated above), dividend paying stocks fit very well into my preparation for retirement with the proof of their outperformance against non-dividend paying stock. More importantly, the power of compounding could leap you right into taking advantages of these annualised returns simply by starting early. If your investment provide you with an annualised return of 7.5% for 10 years and you reinvest all your dividends annually, you could have doubled your investment sum in 10 years. And this sum will then again be doubled in the next 10 years given the same conditions. This will mean that if your investment will be quadruple fold in 20 years simply by the power of compounding! Of course, it's no easy feat to achieve annualised return of 7.5% for 20 years. But I will certainly say your chances are much better with a dividend paying stock from a statistical point of view.

Of course, you will also have people on the other side of the camp waving the "Growth Stock" flag and chanting "Why so hard up for dividends!". I can understand where they are coming from. If you could identify a good growth stock in its early stages of growth, you will have much better better returns than a dividend paying stock. However, you need to also be aware that such growth stocks are by and large not that common, and you shouldn't be hoping that all your stocks turn out to be the next Amazon or Apple. While you might experience huge gains, you are also equally likely to be experiencing huge losses. Statically speaking, you might still be better off with dividend paying stock.

And it should also be noted that dividends investing is merely a tool for your investment plan. You need to drill down into the specifics like the financial health of the company, past and future earnings growth to get to understand what you are buying. Some of these might have already been covered by metrics like payout ratio, but I suggest you to spend some time on the balance sheet of the company if possible.

When used right, dividends investing could very well accelerate your retirement plan much faster than you thought.

Off to enjoy my dividends, oops sorry, sliced bread I mean. #datascienceinvestor

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