What are stock dividends?

Companies exist to generate cash for their owners. That’s their purpose, from the investor’s point of view. Small-business owners understand this. They live off the cash their business generates for them. Yet, in the stock market, most people seem to forget this.

Instead of collecting steady dividend cheques like small-business owners do, too many stock-market investors behave like gamblers. They buy and sell shares at different prices, trying to pocket the difference. But that’s a risky strategy. Stock markets don’t always go up.

In the end, shares only have value if they pay out some of their profits in dividends. Those dividends might still be some way off in the future, but a share that has no prospect of paying dividends isn’t worth anything.

Which stocks pay dividends?

When companies make a profit, the can choose one of two things to do with it. They can reinvest the profits into the company’s expansion. Which makes sense if the company can find enough promising opportunities. Or they can pay the money back to their shareholders in the form of dividends.

Usually, companies that are expanding fast will choose to reinvest their profits into growing future profits. As they mature and sales level off, companies begin to pay out more and more of their profits to shareholders in the form of dividends.

Investors call expanding companies that reinvest their profits “growth stocks”, because they are still focusing on increasing their profits, while companies that pay out a large share of their profits in dividends are called “income stocks”, because they provide investors with income. Some companies are situated in between. They still reinvest a lot of their profit in order to grow future dividends.

Many stocks have dividend policies that constitute self-imposed rules to pay a percentage of profits out in dividends each year, or to pay out a minimum dividend to help investors achieve predictable returns.

Are dividends better than capital gains?

This is one of the most hotly debated questions in financial markets and academia. The answer is “sometimes”, and “it depends who is asking”. Investors who understand when to invest for dividends or capital gains are best equipped to make the most money.

First of all, consider what you are trying to achieve. If you want to generate steady cash payments that are unlikely to leave you hanging, then dividends are a better way to go. If you want to boost your wealth, you should aim for capital gains, or companies that are still growing fast.

Next, consider the investing environment. Growth stocks boom during good economic times when inflation is low. Technological advancement, which requires reinvested profits to finance, is another driver of capital gains.

But times are not always good…

When is the best time to buy dividend stocks? 

During market downturns, investors favour income over capital gains. And so they prefer dividend stocks over growth stocks. Particularly stocks with reliable dividends, such as utilities and consumer-staples companies, such as grocery stores.

Inflationary periods are also a good time to own dividend stocks because dividends can grow with inflation as companies simply pass on the devaluation of money to their customers. According to research by financial conglomerate Fidelity, “Dividends have accounted for 40% of stock market returns since 1930 and 54% during decades when inflation has been high.” And, “When inflation has been high, the stocks that have increased their dividends the most have outperformed the overall market.”

Some studies claim that, as a general rule, dividend-paying stocks are better performers. There are many plausible reasons for this. It’s hard to fake dividends, which means companies that pay them are less likely to be frauds or due to collapse. The popularity of dividends during downturns protects their shares from crashes. And dividends give investors the option to buy more shares, cash the cheques, or invest the money in something else. This makes the transition to retirement smooth. Investors don’t have to sell out, they can simply opt to live off the income from their dividend-paying shares.

When is the best time to sell a dividend stock?

Companies die. It’s a simple fact that they don’t last forever. Managements eventually mess up, products become obsolete, a crisis hits the company or some other stumbling block becomes too much to bear.

Because a company tends to pay out dividends as it reaches maturity and can’t find a good place to reinvest its profits, high dividend pay-outs can be a sign that it’s going to decline or fail.

Investors should avoid dividend stocks that fail to grow their dividends or profits over time. This is a sign that the company has reached its peak.

Which stocks have the highest dividend?

The size of the dividend itself does not tell you whether a dividend is high or low. The dividend yield does.

A dividend yield is the percentage return investors get from buying a share and collecting its dividend. A share with a price of £1 and a dividend of 20p gives a dividend yield of 20%, for example. But an investor would get the same return from a £10 stock that pays a dividend of £2.

Consider another factor – how price affects dividend yield. Because investors prefer high dividend yields, they would likely buy shares paying a 20% dividend. This would bid up the price from £1 to, say, £4 in our earlier example. But the company still pays the same dividend yield of 20p, which means a dividend yield for new investors of 5%.

So, the dividend yield of a company depends on the share price and the dividend itself. This means you can find good dividend returns in two ways. You can buy cheap companies, or companies that are growing dividends fast.

Companies that grow dividends fast can, over time, raise the dividend yield which long-term investors get.

4 UK dividend stocks to consider

1. Commodities and oil

Rio Tinto has increased its dividends over the past two decades, from 50 US cents to over US$10 last year. The huge commodity producer pays out its vast profits to shareholders – including special dividends (one-off “gift” dividends) in unusually good years. But the dividend is volatile as commodity prices go up and down. Oil-producing behemoths such as BP and Shell are very similar.

2. Insurance companies

Large insurance companies such as Direct Line Insurance and Aviva tend to be big dividend payers because of their business models. They turn customers’ insurance premiums into profits and dividends while hoping claims won’t overwhelm their income.

3. Banks

Banks such as HSBC and Lloyds are similar, turning mortgage payments into profits and high dividends. But beware of financial crises!

4. Consumer staple companies

Large consumer-staples companies such as Tesco and Coca-Cola tend to have the stable earnings which lend themselves well to paying dividends. They are also large companies that have matured their growth, so they pay out a high share of their profits in dividend form.

How to buy stocks that pay dividends  

Dividenddata.co.uk is a good website for dividend information, such as dividend yield and historical dividends. Be sure to check whether dividends have grown over time, and whether buying now will give you a good yield.

Each company will provide information about its dividends on its website. This usually includes a dividend policy. If you are investing for dividend income, be sure to understand this policy.

If you’re looking to build a dividend portfolio, check out the holdings of the iShares UK Dividend UCITS ETF here. This fund aims to provide a high dividend return by investing in dividend-paying companies of today and the future. It’s a good place to start looking for dividend opportunities.

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