LEVEL: INTERMEDIATE
In 2012, dividend stocks grew in popularity as investors craved yield. Finding a reliable return on investment is difficult in bad economic times, which is why dividend stocks tend to get more attention than stocks that don’t pay dividends. In good times, stocks will rise in price as the value of the companies rise, and investors may buy these shares for the pure capital gains. When markets are flat or down, and investors still want income, they inevitably turn to dividend-yielding stocks, especially large-cap stocks. That’s because large-cap stocks offer greater stability and usually have a longer track record of paying out to shareholders. AT&T (NYSE: T), for example, has been paying out dividends for decades.
The way dividends work is straight forward: a company will pay a fixed amount to shareholders at regular intervals, usually once per quarter. To continue with the AT&T example, the company pays 44 cents per share of stock to shareholders four times a year. At the stock’s recent price ($37.34 as of August 10th), this meant that the dividend yield is 4.71% (.44 x 4/37.34). This means that a shareholder with stock in AT&T will get a 4.71% return on their investment in the company without selling their shares or having to make any investment decisions. This is passive income in its purest form.
Dividend Yielding Stocks in the Long Run
4.71% is a good yield. Several large-cap dividend-yielding stocks pay out dividends between 2-3%, with a few on the higher end. However, that isn’t the yield that every stockholder in AT&T is actually earning.
Most stockholders bought shares in AT&T sometime in the past, when shares sold at a different price. This means that their dividend yield is also higher or lower relative to the price that they paid for the stock. For example, someone who bought shares on Sept 10, 1999, would have paid $47.50 per share. The current dividend yield on that price is not as good–just 3.7% (.44*4.71/47.5). On the other hand, someone else who bought shares on July 12, 1985, is getting the sort of yield that most investors only dream about. Back then, shares sold for $7.26, meaning that the dividend yield is 24.2% (.44*4.71/7.26). That’s a tremendous yield.
For the purposes of this example, I am ignoring dividend reinvestment, which is a way to make these yields even bigger. You can quickly see why investors are so keen on dividend-yielding stocks, especially as a long-term investment. This attention is usually focused on large-cap stocks, because they are the most stable and most likely to appreciate over time. As large-cap stocks go up in value, companies increase their dividend payouts to make the yields consistently attractive to encourage further investment. In 1987, AT&T’s dividend was 2.5 cents per share, meaning that the dividend has gone up 1,660% over the span of a single generation.
Finding an Entry Point
Without a time machine, it’s difficult to earn the tremendous yields that early investors earn just by holding a stock. The best way that a new investor can maximize their dividend yields is to buy a stock at the right time.
This is when investors act in reverse: they want a bear market, because that makes the dividend stock cheaper. To continue with our AT&T example, an investor who bought shares on January 31st, 2012, paid just 29.41, so that 44 cent dividend yielded almost a 6% return on the investment. While the stock has gone up about 25% since then, the dividend-oriented investor doesn’t really care that much–if anything, higher stock prices are bad, because that means you’ll earn less on your money if you buy more shares. That’s why dividend hunters like bear markets. It’s also part of the reason why Warren Buffett has famously said, “Be fearful when others are greedy and greedy when others are fearful.”