Categories
Income Investing

Why Invest in Dividend Stocks

There are great reasons to invest in dividend stocks. And most are not taught in business school.

Anyone who went to school for finance learned that – all things equal – a company’s dividend policy should theoretically have no impact on your investment decision-making.

Since transaction costs are minimal and taxes a wash, you should be indifferent as to whether you are paid a dividend or manufacture a dividend (by selling shares). In theory, a dividend simply takes something that is already yours (cash on the corporate balance sheet) and places it in your personal bank account.

Reality is quite different – there are great reasons to invest in dividend stocks.

Note: not all dividend stocks are equal. Personally, when looking at dividend stocks I prefer to invest in companies with sizable moats, growing revenues and easy dividend coverage. You shouldn’t chase yields for the sake of it. Some companies have high dividend yields because they are in dying industries and/or the market is anticipating a dividend cut.

At the corporate level, there are a number of arguments as to why some companies should pay dividends. Perhaps the biggest is that dividends enforce discipline on company management by restricting cash flow. This forces managers to limit projects to those with a higher IRR (Internal Rate of Return).

Note: Fast-growing companies with massive opportunities (e.g. Shopify) inherently have a lot of high IRR projects to invest in. For this reason, it makes more sense for these companies not to return capital to shareholders.

In contrast, cash-rich companies that don’t give cash back to shareholders are more likely to waste money on low IRR projects or acquisitions that only serve to bolster executive pay. Instead, these companies should be giving cash back to shareholders who can then re-allocate to companies with higher return projects.

Dividend policy can also signal insiders’ confidence in the future. The current economic crisis is a perfect example. While some companies have recently cut their dividend (e.g. Wells Fargo) to free up cash in a collapsing environment, others have actually raised dividends. A company that raises its dividend during an economic depression signals to the market the resilience of its cash flows. In today’s environment, I’m much more comfortable giving my hard-earned cash to companies that are still raising dividends.

At a more personal level, I like dividends because they help me stay disciplined. A stock with a 5% dividend yield at the time of purchase provides me a 5% return regardless of the stock price. Knowing this, I’m less likely to make emotional buy and sell decisions. It’s purely psychological, but a known cash return that accumulates in my account beats an unknown potential return that sits in a company’s account (or is tied up in other corporate assets).

While I can manufacture those cash dividend returns by selling shares as they increase in value, this requires more intervention on my part. Do I systematically sell each quarter? Or only sell when share prices rise to crystallize some of my gains? Do I sell a fixed percentage or dollar amount? Do I stop selling when prices fall?

While these questions can be answered and a systematic process created, the emotional gyrations of the market could make me change the process at the worst time. In contrast, if a stock declines but I know I’ll continue to receive my 5% dividend I’ll be more inclined to hold on.

If you’re like me, activity is detrimental to your investing returns. The more I sit tight, the better I do. So any investing strategy that helps me avoid unnecessary activity is helpful.

Categories
Income Investing Investing

S&P/TSX 60 Dividend Yields (July 31, 2020)

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Categories
Investing

Should You Wait for a Market Pullback Before Investing?

Should you buy stocks after a 10% or 20% pullback (aka ‘buy the dip’)? Or should you just invest the money when you have some to spare?

Many professional investors often tell people to ‘buy on pullbacks’, but is this actually good advice? It’s a question too few ask.

First of all, investing when markets are falling is easier said than done. Fear often causes people to freeze and miss the dip. However, it turns out this might actually be a weak strategy anyway over the course of a 20-40 year investing horizon.

I don’t have a crystal ball. Instead, I can look at history to better understand what might happen in the future. So I looked during the period from 1980-2020 (using data from The Measure of a Plan) to compare the strategies.

Below I ran eight different scenarios varied by period in market, (1980-2020, 2000-2020 or 1980-2000), monthly account contributions ($250 or $10,000) and investment timing (whenever cash is added to the account, after a 10% pullback or after a 20% pullback).

Check out the outcomes of each scenario below.

Scenario 1: 1980-2020

$10,000 initial contribution / $250 monthly contributions / invest after 10% pullback

Outcome:

  • Investing whenever you have cash on hand: your portfolio would be worth $2,086,459
  • Market timing: your portfolio would be worth $1,877,150

Scenario 2: 1980-2020

$10,000 initial contribution / $250 monthly contributions / invest after 20% pullback

Outcome:

  • Investing whenever you have cash on hand: your portfolio would be worth $2,086,459
  • Market timing: your portfolio would be worth $1,561,538

Scenario 3: 2000-2020

$10,000 initial contribution / $250 monthly contributions / invest after 10% pullback

Outcome:

  • Investing whenever you have cash on hand: your portfolio would be worth $200,967
  • Market timing: your portfolio would be worth $203,039

Scenario 4: 2000-2020

$10,000 initial contribution / $250 monthly contributions / invest after 20% pullback

Outcome:

  • Investing whenever you have cash on hand: your portfolio would be worth $200,967
  • Market timing: your portfolio would be worth $206,677

Scenario 5: 1980-2000

$10,000 initial contribution / $250 monthly contributions / invest after 10% pullback

Outcome:

  • Investing whenever you have cash on hand: your portfolio would be worth $567,834
  • Market timing: your portfolio would be worth $507,104

Scenario 6: 1980-2000

$10,000 initial contribution / $250 monthly contributions / invest after 20% pullback

Outcome:

  • Investing whenever you have cash on hand: your portfolio would be worth $567,834
  • Market timing: your portfolio would be worth $405,611

Scenario 7: 1980-2020 (High Monthly Contributions)

$10,000 initial contribution / $10,000 monthly contributions / invest after 10% pullback

Outcome:

  • Investing whenever you have cash on hand: your portfolio would be worth $59,881,415
  • Market timing: your portfolio would be worth $53,281,817

Scenario 8: 1980-2020 (High Monthly Contributions)

$10,000 initial contribution / $10,000 monthly contributions / invest after 20% pullback

Outcome:

  • Investing whenever you have cash on hand: your portfolio would be worth $59,881,415
  • Market timing: your portfolio would be worth $44,882,739

Conclusion

The ‘buy the dip’ strategy has historically underperformed over long periods of time.

The only period in which the ‘buy the dip’ strategy actually paid off was 2000-2020. This is perhaps because the market effectively followed a W pattern throughout the first half of that period. Still, the outperformance was immaterial – not lifestyle changing.

Moreover, how is anyone to know whether the next 20 years will look like 2000-2020 or 1980-2000? (OK, I have my opinions but I also recognize the infallibility of my forecasts.) Finally, the cost of being wrong during the ‘invest when you have the money’ periods far outweighed the cost of being wrong during the ‘buy the dip’ periods.

Taking everything into consideration, the results are clear: you’re better off investing when you have the money.