Can we agree on the fact that if you want anything to grow, you need to invest in a productive asset? Whether it’s real estate or equities, you need to invest in an asset that is going to work on your behalf. A dividend stock is one that pays something back to the investor; a simpler way of saying it is that the shareholder is rewarded for holding the stock.
Why Invest in Dividend Stocks
If you own a property, say a piece of rental real estate, you will put it on the market, find a renter, then enjoy the income stream in the form of ongoing rent payments. If you invested in our Income Growth Strategy which consists exclusively of the stocks of utilities companies, you would receive quarterly dividend payments – the equivalent of the ‘rent’ produced by a real estate asset.
Return on Your Investments
In our line of work, the productivity of an asset is measured in its capacity to grow in underlying value over time. There are some equities, like the utilities stocks that we feature in our Income Growth Strategy, that yield in the form of a dividend payment. That dividend payment is representative of sharing in the production of a company. Because you invest in, or fund, a company, you are rewarded in the form of a quarterly payment. We layer on top of this, the added aspect of investing specifically in companies that, according to the meticulous research performed by our analysts, are likely to yield a dividend that will be higher this quarter than the one before.
The Power of a Dividend Investing Strategy
Let’s bring this to life with a hypothetical example. Say you decide to purchase the stock of a utility company, and the company pays you a dividend of $1000 for the quarter ending June 30th. This payment represents a portion of the profit of the company, which they are sharing with you for choosing to invest in them. Next quarter, the company continues to do well and on September 20th, your dividend payment is not $1000 but $1100. What do you do with the money? Maybe you spend it. Hopefully, you reinvest in more shares. If you reinvest, you have even more shares of the company working for you. In our example here, let’s say if you don’t reinvest in the company, your dividend payment may grow to $1,150 by December 30th.
Dividend Growth Compounding
But let’s say you reinvested back into the company, you own more shares, and by the next quarter, your dividend payment is now $1,400. This money continues to grow, compounding over time. “Compounding is the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time. This growth, calculated using exponential functions, occurs because the investment will generate earnings from both its initial principal and the accumulated earnings from preceding periods.” (Investopedia)
This to me is the most beautiful thing in the investment world. The dividend is the most integral part of successful investing, and the magic of compounding just adds to its beauty.
Should I Invest in Dividend-Paying Companies?
If an investment doesn’t produce a dividend that doesn't mean it’s a bad investment. The Beck Bode Growth Strategy, our flagship investment strategy, is composed exclusively of equities, none of which produce dividends. Investing in non-dividend-producing equities simply translates to more volatility for the investor. Rather than sharing in the profits of the company in the form of quarterly dividend payments, as investors we are trusting the decision makers of the company to take our money and put it toward the future growth of that company.
There is no right or wrong answer when it comes to “Should I invest in a company that pays dividends” versus “Should I invest in a company that doesn’t pay a dividend?” The right answer is as Nick Murray, one of my favorite writers in the financial world, perfectly summarizes: “Don’t interrupt the compounding.”
How would you likely interrupt the compounding? Well, by going to cash for one thing. Or by considering reallocation to other less productive, asset classes. One of the challenges of being surrounded by 24/7 financial media is that the value of our investments is constantly, relentlessly, flashing before our eyes. You can find out what your portfolio is worth now… and now... and now.
Dividends are a Sustainable Source of Income
On the other hand, when you own an investment property, you don’t have the changing value of your rental property flashing in your face continuously. (I guess you may sign up for a service that periodically tells you how much your property is worth.) Plus getting in and out of rental real estate is not as easy as buying and selling stocks.
Between the lack of liquidity in real estate and the fact that the price of your property doesn’t run on a ticker tape, your emotions are less likely to be tied to the ups and downs of the real estate market the way they may potentially be tied to the ups and downs of the stock market – moment by moment.
As a real estate investor, what will give you a sense of success is the ongoing stream of rent you are collecting. Let’s say you went out and bought an investment property today and you didn't care at all about changes in its underlying value, because you are looking at it as a long-term investment. Every month you collect these rental payments. Every now and then you're able to raise the rent on your property.
Dividends Help Mitigate Portfolio Risk
Over time, say a 20-year span, the property appreciates in underlying value – but are you thinking about that, or are you more concerned about your revenue stream? Chances are what you’re really paying attention to is the steady stream of rent that’s coming into your checking account. In fact, over time, it’s possible that due to the cyclical nature of the economy, the price of your real estate investment experienced some dramatic ups and downs. But you didn’t run out and sell the property. You knew you were relying on the income stream that it was producing.
If only we could bring that same mentality to the stock market. The trouble is that when the value of their investments is constantly being flashed before them, it’s hard for people to think rationally about the long-term appreciation of their assets. They can’t apply the same logic to stocks that they may apply to, say a real estate investment. But it’s no different.
How to Succeed in Dividend Investing
What I love particularly about utilities stocks in our Growth Income Strategy is their ability to produce an income stream, much like rental real estate. And just like real estate, the stocks themselves also have the potential to increase in underlying value. Quarter in and quarter out, we collect our version of “rent” in the form of a dividend payment. If we’re disciplined, we reinvest that so that we can enjoy even more growth.
It's a beautiful thing to experience. All we have to do is stand back so that time and compounding can do their work. All we have to do as financial advisors to support that growth is to prevent our clients from interrupting the compounding.
Ben Beck is Managing Partner & Chief Investment Officer at Beck Bode, a deliberately different wealth management firm with a unique view on investing, business and life.