Dividend & Dividend Growth Strategy

Some new investors are sometimes confused about dividend. In this article, I will try to answer some basic questions, and introduce dividend growth strategy.

First Question: What is Dividend?

Dividend is a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves).

As a company declare the coming dividend, you may see three dates: ex-div date, record date and payable date. The ex-div date is the date after which people buying shares would not be entitled to the dividend. If you buy shares prior to the ex-dividend date, you will receive the dividend. If you buy the shares on, or after the ex-dividend date, the seller keeps the dividend. You don't need to worry about record date, which is usually ex-div +1. Payable date is when you receive the dividend.

Example: $1 div, ex-div 2/1, payable 3/1.
You need to hold the stocks by the end of 1/31 (regular hours). If the stock price is closed at $100 on 1/31, it will start to trade at $99 on 2/1. If you have 100 shares, you will be credited $100 on 3/1. You may choose to take the cash or reinvest in this stock (commission-free). It seems you can only take cash on Robinhood because they don't have fraction shares. If you reinvest,  you can get 1 share if it is traded at $100 when market is open on 3/1 (payable date), making it 101 shares in total. If you have sold the stocks between 2/1 and 3/1, you will get the cash.

If you short the stocks before ex-div date and hold your short position through that, you need to pay the dividend from your pocket. Therefore, dividend-paying stocks in general perform better than others in bear market.

Here is the LINK for ex-div calendar.
(http://www.nasdaq.com/dividend-stocks/dividend-calendar.aspx)

Tax Benefit of Dividend

Most of the dividends are qualified the same as "long-term capital gain", on which you pay only 15% (or 0%, or 20% depending on your income level) federal income tax.

To qualify for the qualified dividend rate, the payee must own the stock for a long enough time, generally 60 days for common stock and 90 days for preferred stock. The dividend must also be paid by a corporation in the U.S. or with certain ties to the U.S.

ETFs (exchange-traded funds) are taxed the same as its underlying assets would be taxed. Therefore, if an ETF has all stock holdings, it gets taxed just as the sale of those stocks would be taxed.

Note: dividend from REIT and mREIT are not qualified. I will explain REIT and mREIT later.

Why do Companies Pay Dividend?

It is one way companies pay back profit to shareholders other than buyback shares. Buyback can support share price level, reduce share counts and boost EPS. Dividend and buyback are not common for fast growing companies. For instance, Amazon and Netflix need all the cash flow to reinvest into business.

Objectives of Dividend Growth Strategy

• Monthly income: for instance, if you have portfolio of $1M stocks average 4% yield, you can get $40k cash a year while you choose to.
• Income growth every year: as you reinvest your dividend or companies hike dividend, your monthly income grows.
• Competitive total returns over time: as you accumulate more shares by reinvesting dividend and share price grows over time, you may end up surprising high total returns for long-term investment.

How to Choose a Good Dividend Stock?

You need to look into three factors: yield, payout ratio and dividend history.

Yield

Yield is calculated as (annual dividend)/(stock price). In the example above, it is 4 x $1 / $100 = 4%. If you choose to take cash, you get $4 every year. After 25 years, you get the investment back (if you ignore inflation) and still hold the 100 shares.

Payout Ratio

Payout ratio is the proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage. However, the ratio is also sometimes expressed as a percentage of cash flow, which excludes non-cash items such as depreciation.

A high payout ratio is not desired as the company has little money to reinvest and the yield is not sustainable or growing. 

Mature companies whose predictable earnings and strong cash flows allow them to pay out a higher percentage of their profits. Examples include telecoms, utilities, pipelines and some other blue-chip companies. Some companies set a target range for their payout ratios (say, 60-70%).

Real estate investment trusts (REITs) and mREITs (mortgage REITs) are structured, for tax reasons, to distribute most of their cash to unit holders. As a result, they have even higher payout ratios, generally ranging from 75-95%. Due to the high payout ratio, the dividend from mREIT often fluctuates --- I have seen as high as 20% yield. At current market, REITs usually have yield of 4-6%, mREITs have yield around 10%.

Dividend History

The company should have a reliable growing dividend history. For instance, Coca-Cola (KO) has increased its dividend payments for 57 consecutive years, Johnson & Johnson (JNJ) has 55 consecutive years of dividend increases. These blue-chip companies have managed to pay consistent dividend through difficult times.

Special Dividend

Besides regular dividend, there is another type of dividend --- special dividend, which is one-time only dividend. It happens when the company has abundant cash and tries to reward its shareholder. Special dividend could also prevent massive short-sale.

Here is an example: Costco paid $7 special dividend on 5/8/2017, although its regular dividend is only $2/yr @ 1% yield. Costco has done this every two years. Therefore, its true yield is 4~5%.

Diversification is Key

Since you eventually want the stable monthly income in this strategy, diversification becomes more important than ever to minimize risks. I would suggest you to build your dividend growth portfolio starting from 4-5 core holdings. Add more companies gradually to 20~30 stocks across all the Sectors (Utilities, Telecom, Retailers, Healthcare, Financial, Industrial, and so on). Make adjustment once or twice a year if needed.

Here is a list of companies (total 23 from screening) with long dividend growth history 50+ yrs

• ABM Industries (ABM)  1.9%
• American States Water (AWR)   1.8%
• California Water Services Company (CWT)   1.8%
• Cincinnati Financial (CINF)   2.8%
• Colgate-Palmolive (CL)   2.2%
• Dover Corporation (DOV)   1.8%
• Emerson Electric (EMR)   2.7%
• Farmers & Merchants Bancorp (FMCB)   2.1%
• Federal Realty Investment Trust (FRT)   3.4%
• Genuine Parts Company (GPC)   2.6%
• Hormel Foods (HRL)   2.2%
• Johnson & Johnson (JNJ)   2.4%
• Coca-Cola (KO)   3.1%
• Lancaster Colony (LANC)   1.9%
• Lowe’s (LOW)   1.6%
• 3M (MMM)   2.2%
• Nordson (NDSN)   0.8%
• Northwest Natural Gas (NWN)   3.3%
• Parker-Hannifin (PH)   1.4%
• Procter & Gamble (PG)   3.2%
• SJW Group (SJW)   1.9%
• Stanley Black & Decker (SWK)   1.4%
• Stepan Company (SCL)   1.2%
• Tootsie Roll (TR)   1%
• Vectren (VVC)   3%

Other popular picks:

mREIT (~10%): AGNC, NLY, TWO

REIT: O 5.1%, MAA 4%, OHI 10%, KIM 7.3%, WPC 6.3%, HCN 6%, FRT 3.4%

Many more: T 5.1%, MO 3.8%, PM 4.1%, COST 1%, KR 1.7%, M 5.9%, KSS 3.4%, GPS 2.8%, SBUX 2.1%, DIS +1.5%, HAS 2.4%, KMI 2.8%, DWDP +2.1%, WM 1.9%, HCP 6.3%, AMGN 2.5%, GILD 2.5%, CA 1.9%, BA 1.6%, FL 2.5%, NKE 1.2%, UPS 2.7%, XOM 3.5%, CVX 3.6%, COP 2.7%, HD 1.8%, STX 4.6%, IBM 3.7%, AAPL 1.5%, LMT 2.2%, HON 1.9%...