Ever wondered if you could retire with just dividends? In this article, we explore is it possible to live off dividends and explain how to get there. We share our dividend investing strategy, making money from dividends and more importantly how we select dividend stocks.
The power of dividends
While many investors are looking to make a quick buck, the power of dividends is often overlooked by many market participants today. A consistent outperformer, dividend contributes just over 45% of the total return, based on our analysis. In fact, if we go back further in 1970s, as much as 75% of its return can be attributed to dividends reinvestment and the power of compounding.
The fact is clear and the theory is proven, so why are investors not going all in into dividend stocks then? In our view, dividend investing a game of patience (often slow and boring, but stable), that’s point one. And secondly, the thrill of short-term trading and the get-rich-quick mentality of some groups of investors dissuade them from being a long term investor.
Making money from dividends
How is dividend investing different from investing in non-dividend paying companies? The answer lies in the composition of total return. Specifically, the source of return for non-dividend paying stocks come the appreciation (or depreciation!) of its stock price. On the other hand, dividend stock is a combination of both stock price appreciation and dividend.
In addition, non-dividend paying stocks tend to be a riskier bet as 100% of your return are likely to come from the share price itself. This means a slight headwind or bad news for the stock may have detrimental impact to your total return. Obviously, we are aware that high risk may imply high return.
Broadly, there are two ways of making money from dividends. First, being reinvesting dividends back into the stock. This approach benefits from the power of compounding. The disadvantage, however, is the lack of passive income given that what is paid out is reinvested. The second approach is opt out from dividend reinvesting. This would be the default choice in building a passive income stock portfolio.
Dividend policy examples
Usually, companies provide guidance on its dividend policies. There are largely two variations
- Regular dividend policy. This is a common feature of more mature companies who target a dollar amount or payout ratio. Companies usually target to grow its dividends in line with earnings.
- No dividend. This usually applies to companies who are either in a high growth phase (ie tech companies) or companies who are unable to pay due to financial reasons. Read our write-up on Lemonade Inc here.
The importance of dividend policies cannot be underestimated as it builds consensus in the market. It provides a roadmap of what to expect.
Dividend growers vs dividend payers
Is it enough just to invest in any stocks that pays dividends then? Almost always, the answer is no. The objective is to invest in companies that can produce a sustainable and growing dividend.
Dividend growers are companies that has a progressive growth dividend policy. For example, a company growing its dividend by 5% annualy. In essence, dividend growers are dividend payers that grows its dividend.
In fact, this group of stocks has traditionally outperformed its peers. In our view, this is a result of its resilient business models combined with the commitment to grow dividends across boom and bust cycles.
Is it possible to live off dividends?
The big question among investors (at least for me when I started) is how much do you need to invest to live off dividends? It is theoretically possible to live off dividends.
However, you need a large amount of capital invested to achieve that. In an equity context, you will also need to manage the timing of dividends as most companies pay biannually, quarterly or annually.
A back-of-the-envelope calculation is simply your targeted dividend income, divided by the expected dividend yield. For example, if you’re targeting $30,000 per year with an expected yield of 5%, you will need $600,000!
What is a good dividend yield of growth rate?
So, how do you determine what is a good dividend yield or growth rate? While some market commentators think a good yield should be between 4-6%, investors need to appraise opportunities on a comparable basis.
We think dividend yield and growth should be considered in their relative context. For example, considering if a sector’s average yield is 2%, does it mean we should ignore the sector altogether?
Our approach is to start by selecting a sector. Next, filter the companies by historic and future yield. We can also derive the respective dividend growth rates and the averages, given historic dividend yields.
Determinants of dividend policy
The key determinant of dividend policy is its earnings and free cash flow. For most companies, this is the bottleneck on how much they are able to pay out. In general, companies do maintain some form of “rainy day fund” or cash at hand as a buffer for its dividend policy.
The amount of buffer held can range from 1-3x the dividend paid in previous years. If all else fails, dividend may be cut or rebased (management speak for dividend cut).
In our experience, this usually ends up very negatively for its stock price. Often, companies must have exhaust all options before proceeding with this.
Reasons for paying dividends
In general, companies can do 4 things with its profits
- Pay dividends
- Repurchase share / share buyback
- Acquisitions (to grow inorganically) or to pay down debt
- Reinvest back in the company (to grow organically)
For companies, it’s a decision of what’s best for the both the company and shareholders. Often, the decision to pay dividends is about creating stability among investors. On one hand, paying dividends is a way to reward shareholders. While on the other, it’s to build confidence in the market on the future prospect of its business model.
Dividend investing strategy
Almost every dividend investing article in the media today is revolves around common stocks. But, what about including preferred stocks / preference shares as part of your strategy? In short, preferred stocks are another class of equities that shares some characteristics of bonds and common stocks. Higher ranking than common stocks (meaning they will be paid first in events of liquidation and dividends), preferred stock owners are paid a fixed dividend agreed at outset.
For this reason, it could be viewed as a stable consistent stream of income for investors seeking greater certainty. For more detail on this, see our full guide on investing in preferred stocks.
What to look for from dividend paying stocks?
Prior to doing further in-depth company analysis, we screen companies with the following criteria. Our dividend investment strategy can be summarized as follows.
First, track record. We look for both consistency and track record of growing dividends. Consistency refers to how regular and stable dividends are over business cycles. Owing to the fact that dividend growers tends to outperform, we are biased towards sustainable dividend growth rate. For example, Direct Line Group has paid and continuously grew its base dividend since its IPO in 2011.
Secondly, payout ratio. This measures the proportion of earnings that is distributed as dividends. As a rule of thumb, we look for companies with around 50-70% payout ratio.
Next, besides traditional price-to-earnings and price-to-book ratio, we focus on current and future dividend yield. While the past is covered in “Track record” above, future dividend yield has always been the main source of uncertainty. A good indicator is to use the historical average dividend growth to get an idea of what you should be expecting going forward. In the current climate, we target a forward dividend yield of ~4-5%.
Finally, leverage ratio. Debt repayment is an obligation, whereas dividend is optional. Being mindful that interest payments have precedence over dividend, we prefer companies with leverage ratio (measured as debt/equity or debt/(equity + debt) ) of <25%.
Creating a stream of passive income is the goal of many and dividend investing is one of the many ways to achieve it. The power of dividends and compounding effect have often been underappreciated by the market, often in favor of stocks with big short-term upside.
Our take for investors wanting to construct a successful dividend portfolio is to look for
- Stocks that has a track record of delivering stable and growing dividends.
- Stocks that has historical payout ratio between 50-70%.
- Dividend yield that make sense with your risk appetite.
- Leverage ratio of <25%.
Living off dividend may be a bit farfetched today, but, starting your journey today is always a good idea. The power of dividends will surprise you!