The Dividend Illusion

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

We are living in an era of a zero-percent interest rate environment. In such abnormal conditions, savers are pushed against the wall and are forced to compromise for a relatively low yield on their savings. This, in turn, initiates a furious pursuit after any security that provides a reasonable yield. 

The fallacy

Many dividend investors have got it all wrong. They believe that in order to obtain satisfactory results from their portfolios, they must buy and hold stocks with high dividend yields. As they see it, a stock with a 3% dividend yield will always be inferior to a stock with a 7% dividend yield. In my opinion, nothing could be further from the truth.

The Dividend Yield as a Signal

In most cases, an exceptionally high dividend yield is usually a sign of  trouble. Yields tend to regress to the mean, which is usually  between 1.5% and 4%, depending on the time period and the economy. Chasing a stock with a 12% yield in order to enjoy the high level of payouts usually means a great capital loss to the investor down the road. Having said that, there is a much better way to guide your path in dividend investing.

What has Worked for Dividend Investors

There are two simple rules to follow when considering any investment for dividends:

  1. Always make sure that the company has a proven track record of paying dividends. Take Becton Dickinson (NYSE: BDX), for example. The medical device giant has been paying dividends since the year 1962! Now, how many companies do you know with such a long proven track record of delivering to shareholders?  You can look up the company's dividend history here. As a rule of thumb, if a company has been paying dividends longer than you have been around, you can count on those dividends to keep coming.   
  2. Check the rate of the company's dividend increases. Put simply, always consider how consistent the company is in increasing the amount it distributes back to shareholders. Take, for example, the giant software company Microsoft (NASDAQ: MSFT). Since Microsoft first initiated a dividend back in 2003, the company has increased its dividend payout at an average rate of 15% per annum. That is a fantastic rate of increase. Such a high rate will always insure that investors beat inflation AND make nice returns on their invested capital. In order to fully grasp the power of dividend hikes, take a look at the table below, this is extremely powerful stuff.
<table> <tbody> <tr> <td>Annual Rate of increase</td> <td>After 5 years</td> <td>After 10 years</td> <td>After 15 years</td> <td>After 20 years</td> </tr> <tr> <td>15%</td> <td>6%</td> <td>12%</td> <td>24%</td> <td>48%</td> </tr> </tbody> </table>

Shares of Microsoft currently have a dividend yield of 3.3%. Let's be conservative and call it an even 3%. After a consistent annual increase of 15%, for five years in a row, your dividend yield will equal 6% on those original shares even if the stock has not moved at all during that time period. Fast forward 5 more years, and you will be sitting on 12% dividend yield each and every year without doing anything extraordinary.

And it has been done before. Warren Buffett, the legendary investor is able to generate 50% each and every year on his investment in Coca-Cola (NYSE: KO) from dividends alone. How did he do it? he bought a large chunk of Coke shares back in 1988, sat back, and allowed the company to increase dividends at a rate of 12% per year. That is a spectacular way to invest but you must make a bet on the right company, a company that is able to support such a consistent increase in its dividend payouts.

 The Foolish Bottom Line

I believe that if you follow these two simple rules, you are bound to stay away from financial trouble and start paving your way towards financial success.


shmulikarpf has no positions in the stocks mentioned above. The Motley Fool owns shares of Microsoft. Motley Fool newsletter services recommend Becton, Dickinson and Co., The Coca-Cola Company, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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