How and Why You Must Invest for Dividends

How and Why You Must Invest for Dividends
April 25, 2017 K Compare Senior

Investing for Dividends how and why you must invest for dividends - Investing for Dividends - How and Why You Must Invest for Dividends

We have stressed the importance of saving time and again. Putting your savings to work is equally important. Once you have saved up an “emergency fund” worth around 6 to 9 months of your average expenses, it is crucial that you make smart decisions with any savings beyond that point. One of the best ways to accumulate wealth in the long run is through investing in the stock market. We need to get rid of the perception that investing in the stock market is too risky, or only reserved for those with huge amounts of capital or technical knowledge about the industry. Yes, it is risky and does require some research, but it is also easily accessible for the public and you can start investing with only a few thousand rupees. It is important to do your homework before you invest your hard-earned money with a stock broker, but there is a tremendous amount of information and guidance available for free on the internet. If you follow certain fundamental rules and concepts around investing, you are likely to eliminate a great amount of risk. Seeking investments that would pay dividends is one of the basic foundations of good investing. You can establish a reliable income stream and build wealth in the long run.

What are dividends?

In a nutshell, if a company earns profits, the Board of Directors decide how much profit to reinvest in the growth of the company, how much to use to service the company’s debt and how much to pay out to the shareholders as a dividend. Dividends are taxed at 10% for filers and 15% for non-filers in Pakistan and the tax is to be deducted at source, i.e. you will receive your payment net of tax.

Rule # 1: In it for the long haul

“The single greatest edge an investor can have is a long term orientation” – Seth Klarman.

For those of you wondering who Seth Klarman is, he’s a billionaire investor and hedge fund manager with over $31 billion in assets under management and a personal net worth of over $1.5 billion. Surely a reliable source of advice.

Investing in the stock market to make a quick buck is a terrible strategy. Patience is key and you should always look to pick stocks that you would feel comfortable investing in for the next 3 to 5 years at the very least. Think of it as a fixed deposit. You set aside an amount of money for a fixed amount of time and forget about it. The difference is, a fixed deposit will give you a modest, usually fixed annual rate of return around perhaps 6 to 7% if you are lucky, whereas a dividend paying stock could return much more (or much less). The main advantage you have by investing in stocks rather than fixed deposits is that there are two sources of wealth building: the dividends and capital gains as the price of the stock appreciates. This could very easily lead to a loss if the stock price depreciates over time, which is why your research is important. It is very easy to be shaken up by a period of depression in the stock market when you might see the value of your investments fall. But, if you have invested in fundamentally sound companies that have an established history, chances are they will recover eventually, which is why investing in the long run is key. It also brings me to my next rule.

Rule # 2: Quality over quantity

You should be looking to invest in high quality businesses with a proven track record of stability, growth and profitability. One of the key metrics to look for is the dividend yield. This is the dividend paid out expressed as a percentage of the prevailing stock price of the company. If a company pays out a dividend of Rs. 5 and its stock price at the time was Rs. 100, the dividend yield is 5%. The higher the dividend yield, the better return on investment you receive. But there is a catch. The company may be paying too high of a dividend for its own good, meaning the current payout levels may not be sustainable. This is why you must also assess the company’s dividend payout ratio. This is the dividend per share divided by earnings per share. In other words, what percentage of the company’s net income was paid out as a dividend. If this is too high, that means the company is distributing most of its profits to shareholders and may not be retaining enough to sustain future growth. So, just because a company has paid out a high dividend for a year or two may not be a good enough reason to invest since it is likely that it may have to cut dividends in the future if the payout ratio is high. It may be better for you to sacrifice a bit of dividend yield in the short term in exchange for long term reliability. I would suggest looking at the dividend history for the last 10 years before investing in a company. Here are some of the leaders in these categories from 2016:

Company Dividend Per Share (Rs) Dividend Yield Payout Ratio
Kot Addu Power 9.05 12.30 89
National Bank of Pakistan 7.50 11.96 69
Engro Corporation 24.00 7.29 18
MCB 16.00 7.48 81
Pakistan State Oil 16.50 3.99 33
UBL 13.00 5.58 57
Dawood Hercules 13.00 10.33 24
Fauji Fertilizer 7.90 8.36 84


Rule # 3: Always think Blue Chip first

“Blue Chip” companies are those that a have a reputation and history of stability and profitability. Stressing further on Rule # 2, the quality of the companies you invest in is paramount. Generally, blue chip companies like Engro Corp and others listed in the table above will consistently pay out healthy dividends. Since these are established companies, their stock is considered low risk as they are likely to survive any economic downturn. Capital gains may not be significant in the short run, but hey, we aren’t concerned with the short run, right? When allocating your funds to a portfolio of stocks, I would recommend allocating at least 50 to 60% to blue chip companies.

Rule # 4: Growth potential

Along with the past and present returns, it is also important to determine what direction a company is headed in before you decide to invest. There are two schools of thought when it comes to investing – growth investing and value investing. In growth investing, you focus on long term outlook for the company’s profitability from a dividend and capital gains standpoint rather than what the stock is currently trading for. Value investing is when you try to pick stocks that you think are undervalued and have potential for capital gains, primarily in the short run. You want to pick the companies that are trending in the right direction and have the potential to increase dividend payouts in the future. It requires patience, which is likely to be rewarded with long term wealth accumulation.

Rule # 5: Diversification

You should look to balance your portfolio in every way. After selecting blue chip stocks to invest in primarily, you should then turn to newer companies that have good potential. On the other hand, diversifying the industries you invest in is also important. Concentrating your investments in a specific sector of the market has its benefits, especially if the industry is booming. But, it could prove problematic during a market downturn. For example, the cement industry in Pakistan has been extremely successful over the last year or so and stocks have soared, primarily because of CPEC and the amount of infrastructure projects being initiated. The industry could suffer a setback if there are any future complications with CPEC or if something does not go as planned, so it is not advisable to put all your eggs in one basket. Diversification reduces your risk; if one stock does not perform as expected or does not payout the dividend you hoped it would, it could always be offset by another stock that outperforms your expectations.

Rule # 6: Survival of the fittest

Investing in the long run requires a lot of patience. A certain stock you have invested in may not be performing as you had expected. It may go on for some time, but eventually there is a fine line between waiting for the investment to pay off and hanging on for too long. The stock market is a risky place after all and you are always likely to suffer some setbacks. In those instances, it is important to know when to cut your losses. Reducing dividend payout from year to year is considered a cardinal sin for companies – they would not do it unless they absolutely had to. This is because it sends out a negative signal to the market and could trigger a downfall in the company’s share price. If a stock that you own reduces its dividend payout from the previous year, you should consider why. It is possible that the company may be in troubled waters or may have lost its competitive advantage, in which case you should act swiftly and take your money elsewhere and invest in a more stable business. There is no room for emotions in business decisions.

Conclusion:

Investing for dividends can really have a snowball effect on your wealth in the long run. It requires some of your valuable time and effort to research and identify which stocks offer the strongest return at the least amount of risk. Of course, it sounds easier than it is, but there is a ton of information out there and there are also professional fund managers and advisers who do this for a living. There will always be winners and losers, but in the end, all you need for a lifetime of successful investing is a few big winners.

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