What is dividend investing?

The buying of stocks that payout dividends (we can call it dividend investing) is worldwide very popular. A dividend payment is a periodical payment from a company to it's shareholders. This dividend payment is a reward for the investors who take the risks of investing in the company. This is mostly 1 time per year in Europe. In the US these payments are more frequent. The ex-dividend day is the day the investor has to have the stocks in order to have the right to receive the dividends.

As an example, let's say the Nestle share is now trading at USD 30 and will pay 1 dollar dividend next week, then normally at the ex-dividend date the share drops 1 dollar. Investors living in US can visit the US website Valuespectrum. com with information about dividends. So, the investors who owned the stocks on the ex-dividend date will receive the dividends. The investors who didn't own the stock at the ex-dividend date will not receive it. On balance we call this a zero-sum operation. It makes no difference at all. So what does it matter in the end if we buy dividend-paying stocks or not if it's a zero-sum on the short term? In the short term the buying of dividend-paying stocks makes totally no sense.

This is because that information about dividends is most of the time very well processed by the markets (market efficiency). So a higher or lower dividend is totally not relevant as the markets discount this information.

Why we prefer dividend stocks

Why would it be relevant to buy shares that pay out dividends? When looking back at the longer history we see quite a huge outperformance by the dividend-paying companies versus the companies that didn't pay out dividends.

Paying out dividends can be seen as a quality indicator. In case a company doesn't pay out dividends could mean it's just capable / doesn't earn enough. The fact that companies can pay out dividends can be seen as a quality indicator.

Of course this is very short-sighted as there are many other variables that influence the company's quality (read: under- or overpricing). In the short term we don't see any differences between the dividend-paying and non-dividend paying companies. But when we look at the long term we see higher total returns (price returns + dividend returns) for the companies that paid out dividends. This is mostly caused by the interest effect. This is an exponential effect caused by the re-investing of dividends. This creates a kind of snowball effect.

You can see it like a young tree that gives more apples after time passes. This compounding effect was called the world's 8th world wonder (by Albert Einstein). Well-known dividend investors are T. Boone Pickens, Jorik Van den Bos (Kempen) and Maria Bartiromo.

Dividend taxes

Dividend tax is the part that is kept by the governments. Mostly investors can restitute a part of this back. One of the reasons for taxing dividends separately is to prevent tax avoidance: in a system without dividend taxes it is possible to have money streams via the dividend payments in order to avoid income taxes. For foreign investors, it's mostly only interesting to try to restitute all of the dividend taxes as the cost of restituting it is very high.

This is caused by the very high administrative costs which are normally way higher for the general investor than the withheld dividend taxes. Normally the breakeven point is around 250 dollars. This means in case your withheld dividend taxes are less than 250 dollars it makes no sense of claiming it back.

Dividends vary

Dividends are never stable and vary throughout the time. Companies can easily announce stopping paying dividends to their shareholders. These insecurities almost always have a big impact on the share price.

When a company says it will decrease its dividend we almost always see direct responses at the financial markets. Of course, this is because that current shareholders will earn less (they receive less or no dividends). So in case, there are dividend adjustments we almost always see this back at the stock and options exchanges (in case options are listed on the share).

Watch out for the value trap

investing based on a dividend strategy is all but an easy strategy. Historical dividends are just historical data and hardly say something about the future. This also because of the market efficiencies. For investors is absolutely relevant to focus further than just the dividend yield in order to avoid the value trap.

The focus on just high dividends could probably end up in a portfolio with low-quality companies. It's crucial that investors have a total picture of a company's most relevant financial variables. Can the company afford to pay out the dividend is the big question.

Relevant financial variables that influence the company's dividends.

The risks of too attractive dividends

Of course it's very logical just to hunt for the companies that pay out the highest dividends but it's not that easy. A dividend yield of let's say 6 percent is very rare and also quite dangerous. Bells should ring now. With this we mean that the effective dividend yield is way too high: either the dividend per share is too high or the stock price is just too low.

Both are possible but in the financial markets, you never know it. There are lots of examples of famous companies that had high expected dividends but needed to lower or even stop them and got bankrupt.

Think of for example Lyondell Chemical, General Motors, and MF Global Holdings. Most of these shares had very high expected dividends and so extreme dividend yields. But when these dividends per share were lowered or even stopped the stocks crashed. And for most of them even further crashed after announcing the redemptions of the dividends.

The height of the expected dividend per share is nothing more than the consensus of the analysts. Of course, companies also provide news about their future dividends but the current shareholders always need to agree with that at the general stockholders' meetings. But in practice we rarely see it happen that current shareholders propose a lower dividend per share.

Returns USD 100 invested in European Dividend aristocrats

Dividend Aristocrats

Dividend Aristocrats are these companies that always have raised their dividends each year in their history. Of course, this total number is getting smaller and smaller each year. Famous dividend aristocrats are BB&T, Brown-Forman and M&T Bank.

The returns of most of these companies had been magnificent in history. This is partly caused by the interest effect (the re-investing of received dividends). But please don't focus too much on this.

These are just past figures, performances, returns, data etcetera and don't tell us much about the future. In the end, there is no company that can ever keep on raising its dividend. So forever rising dividends are a fairy tale. But the Dividend Aristocrats' long-term performance clearly points out the positive effects of the re-investing of dividends.

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