The Ten Commandments of Dividend Investing
Investors love dividend stocks—they pay you regularly just for holding them, they’re less volatile than other stocks, and over time, they actually deliver higher returns too. Investing in dividend stocks isn’t hard, but it is a little different from growth or value investing, or other strategies based purely on capital appreciation. Following rules designed to maximize capital appreciation can actually hurt your overall returns when buying and selling dividend stocks.
The 10 Commandments of Dividend Investing
Research Tips to Find the Best Stocks
What are Your Investing Rules?
The Ten Commandments of Dividend Investing
Investors love dividend stocks—they pay you regularly just for holding them, they’re less volatile than other stocks, and over time, they actually deliver higher returns too.
Investing in dividend stocks isn’t hard, but it is a little different from growth or value investing, or other strategies based purely on capital appreciation.
Following rules designed to maximize capital appreciation can actually hurt your overall returns when buying and selling dividend stocks.
So what’s different about dividend investing? To make it easy, here’s my list of the top 10 things dividend investors must remember—I call them the 10 Commandments of Dividend Investing.
Dividends are King
Thou Shalt Do Your Research
Follow the Money
Take a Long-Term View
Thou Shalt Be Patient
Thou Shalt Start Early
Thou Shalt Diversify
Thou Shalt Not Covet
Know When to Admit Defeat
The first rule of dividend investing is the simplest: Dividends are King, heed them. A stock that’s been increasing dividends for 40 years is a reliable dividend payer. One that’s been paying for two years may not be.
If you start your investing screens by looking at dividends directly, you’ll be surprised how many unworthy companies you can weed out right off the bat.
The second Christian commandment is Thou shalt have no other Gods; in dividend investing that’s simply bad advice. Dividends are important, but for long-term investments, so are a whole host of other factors. Once you’ve narrowed your pool of investments down to worthy dividend payers, it’s time to look deeper—at cash flow, industry factors, technical trends, balance sheet condition—anything else that could have an impact on the company or the stock going forward.
Why is research so important for dividend investors? If you’re buying a stock with the intention of holding it for years, or even decades, you want to fully understand the investment and the potential pitfalls you might run into. A superficial understanding of stock is fine for a trader who only plans to hold a few months and will sell when the going gets rough, but long-term investors need to do their due diligence.
Before recommending anything to my Cabot Dividend Investor members I run multiple screens, check financials and historical data from several sources, and read pages and pages of quarterly earnings, annual reports and conference call transcripts. Don’t have time to do all that yourself? I think you know what I’d suggest.
Once you drill down into the bowels of a potential investment, the best way to really assess its long-term ability to keep paying that dividend is the simplest: follow the money. And by money I don’t mean EPS numbers, which include a host of “non-cash” charges, one-time expenses, and other accounting trickery. I mean the actual money, which in investing parlance is called cash (even if it’s mostly digital transfers). I see Free Cash Flow (FCF) as the best measure of a company’s actual income stream, but Operating Cash Flow and revenues can also be useful. You want to see cash flow that’s consistent, gradually growing over time, and covering both expenses and the dividend.
Looking at cash flow is a great start, but you have to make sure not to extrapolate a few quarters of strong FCF into a long-term trend. A company with three consecutive quarters of great cash flow and great growth estimates for the next two quarters might be a good holding for the next few months, but how will it be faring in five, 10 or 20 years?
On the other hand, if a company has regularly increased cash flow year over year for decades, you can be fairly sure that the business isn’t going to collapse next month. These companies aren’t a dime a dozen, to be sure, and the difficulty of generating regular cash flow year in and year out is why so many great dividend payers come from “boring” industries and sell products like paper, laundry detergent and fertilizer—stuff people need every year, regardless of what’s trendy or how the economy is doing.
Now that you’ve found the perfect investment and pulled the trigger, it’s time to sit back and relax.
When I say long-term investing, I mean long term. In the Dividend Investor portfolio, we aim to hold our safe income investments for decades. As Warren Buffet has said, his favorite holding period is forever.
A subscriber wrote to us a few months ago to tell us he was enjoying Cabot Dividend Investor, and that “I would tell people to check it out as a long-term strategy for those who don’t want to worry about timing the market and watch it on a daily basis.” That’s the perfect attitude to have.
So-called long-term investors who still check on how their investments are doing every day are more likely to get whipsawed out of them suddenly during short corrections than to accumulate large profits over time. It’s also not good for your stress levels.
Occasionally a Dividend Investor member contacts me concerned about one of our holdings—they’re afraid of losing money, or they want to take profits. Most of the time, the problem is that they bought something that wasn’t right for them. I tell my subscribers, if you can’t sleep at night, you’re doing it wrong.
On the other hand, if you’re sitting on your hands watching an investment trade sideways for months and you’re simply dying to do something, you might have the opposite problem. If sitting back and relaxing isn’t your strong suit, add some shorter-term positions to your portfolio to give yourself something to do day to day.
Whether you’re an active trader or a risk-averse buy-and-hold investor, it’s important to Know Thyself.
Anyone who’s seen a mathematical explanation of compounding interest knows why this is the retirement advice given most often. Plus, buying dividend stocks before you need regular income from your portfolio can often guarantee you a fatter income stream once you do, through dividend growth and dividend reinvestment.
But, if it’s already too late for you to start early, remember the famous aphorism (the Internet says it’s a Chinese proverb, but who knows): “The best time to plant a tree was 20 years ago. The second best time is now.”
Actually a good rule for all investors, diversification will keep your portfolio from getting wiped out by any one sector downturn or macro event. For investors who depend on their portfolios for income—and aim to hold many of their investments through corrections—it’s especially important to be able to ride out these events. Read more about how diversification can help you weather market crises in this recent article from Cabot Wealth Advisory.
It can be hard to sit back and trust in the long-term value of your blue chip portfolio when you hear traders boasting about their overnight successes in Twitter, Alibaba or the latest hot new IPO. But overnight success is fleeting, while a steady income stream is forever. If envy does start to set in, just think about how smug you’ll be when their social networking darling turns out to be the next Pets.com.
Lastly, even long-term investors sometimes need to sell. Maybe you bought a company with a great long-term track record, but your timing was lousy and the stock is tanking—it’s okay to sell now and maybe try again later. It’s also important to remember that nothing lasts forever: newspaper companies and American car companies were great long-term investments for many decades, but even long-term investors should know how to recognize the end of an era when it arrives.
What Are Your Investing Rules?
Are you a dividend investor with your own list of rules to invest by? Or have you broken some of these commandments in the past and lived to tell the tale? Let me know by replying to this email and I may print some of your personal experiences in a future Cabot Wealth Advisory.
Your guide to a secure retirement,
Chloe Lutts Jensen
Chief Analyst, Cabot Dividend Investor