Investing Series: Overview of Investing in Dividend-Paying Stocks

This is a part of the Investing Series.

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Investing in dividend paying stocks is exactly as it says — investing in stocks that pay you a dividend (usually every quarter).

Keep in mind that all governments tax on all dividends given to all investors worldwide.

Scroll down to the bottom of the page to read about how it works as a Canadian investor dealing with U.S. dividend-paying stocks.

WHAT ARE DIVIDENDS?

Basically, a company has a right to give some money every quarter (or whenever they want to), to their shareholders, usually at $0.01 a stock or something along those lines, and this is called a ‘dividend’.

DIVIDENDS JUST SOUND LIKE A RE-DISTRIBUTION OF MY OWN MONEY….

Yes they are a re-distribution of your own money back to you, in a sense. When you get $0.01 from each dividend-paying stock that you own, they’re basically just giving you your own invested money… back.

Take my company as an example.

I have my money in my company where I am the sole shareholder, and I take it out in dividends annually as an individual investor.

At the end of the day, I’m just re-distributing my own money (from my company) to myself (as an individual).

SO WHAT IS THE POINT OF THIS STRATEGY, THEN?

A lot of people spend their time building and accumulating a portfolio of dividend-paying stocks so that they are able to essentially make an income off these dividends, and won’t have to work.

The idea is that if you have enough stocks in your portfolio, all paying you dividends every quarter, you can consider that a legitimate income.

In fact, a lot of heirs and heiresses to family fortunes are shareholders like Johnson & Johnson for instance (JNJ pays an excellent dividend), receive a cheque or some sort of income every time the company declares a dividend, and that’s the money they use to live as an income without having to sell any stocks (a.k.a. “divest”) any of their portfolios.

Watch & Read: Imagine if you were ‘Born Rich’

If you also take those dividends and re-invest them back into buying MORE company stock, it’s almost like you’re getting stocks for free as time goes on, and each additional stock will continue to make you more money, and so on and so on.

Kind of like a snowball rolling down a hill; it just takes a critical mass of snow before it really picks up momentum and gets going.

WHAT’S THE DOWNSIDE?

I ONLY SEE THEM GIVING ME MONEY, IT LOOKS GOOD SO FAR

It’s a good concept, but I am of the belief that this strategy COULD hamstring investors into chasing down companies that pay out high dividends, but either don’t do it regularly, or they end up hurting the company financially because they can’t really afford to be doing that.

SOME INDUSTRIES DO IT BECAUSE EVERYONE ELSE IS DOING IT

Some industries are more aggressive in handing out dividends, like oil & gas, and you may find yourself heavily weighted into it without taking into account that if the industry has a bad year, so does your dividend income.

If you look around at groups of companies in the same industry (banks for instance), you will start to notice trends in how much they give out as a dividend each year.

As I mentioned above, some companies may end up not being able to keep up with the dividends, or will drop the dividend payout to grow their company and/or for other reasons. Then poof! your dividend stream is done.

YOU NEED A LOT OF CAPITAL TO START SEEING ACTUAL MONEY YOU CAN USE

If you think about it from another point of view, it can seem a bit silly as well: Let’s say you invest $50 into a stock that pays you $0.04 every quarter, or $0.12 a year.

You are now earning about $0.12 / $50 = 0.24% of an income from your investment of $50, with the chance that it will increase over time.

However it will take a while before building enough of those $0.12 dividends will create an actual income stream.

The above was an example of a low-paying dividend stock, as there are ones out there that are high-paying dividend stocks with what is called “better yields” that pay about $2.88 for $60 invested, or 4.8% of a return on your capital.

The problem again, is to avoid chasing down high-paying dividends solely for the dividends. Now if the stocks were just handed to you for free (like if you’re an heir), why not?

You’re getting money and the dividends for free.

But if you earned that money, and you are trying to make an income off dividends paid out by your portfolio, you may miss out on many other opportunities and the benefits of not touching your stash in an index fund.

IT TAKES WORK, TIME, RESEARCH, AND MORE WORK

If you aren’t interested in spending 10-20 hours a week reading on stocks, reviewing your portfolio, checking up on them and making sure you don’t lose your initial capital, then I suggest INDEX FUNDS.

Read: Investing in index funds

This is why looking at dividend investing as PART of your investing strategy is a good idea, but you shouldn’t only focus on chasing down high dividend-paying stocks and pigeonholing your portfolio.

Or if you want to stick with dividend-paying stocks as your main strategy, you better stay strong, do your research, and accumulate over the years to the point where the dividends start paying back.

YOU MIGHT ALSO SEE THE STOCK ITSELF GO DOWN IN VALUE

With the above example, if you bought the stock at $60, you might see it drop in value to $20! (Worst case.) If you owned 13,888 stocks x $40 (loss per stock), you would have been out about $555,520 because the company took a nosedive.

Was it worth the $0.12/a year in dividends for a $555,520 loss?

Only you can say, but hopefully your company just had a bad time, and is going to go back up to its normal levels soon.

This is another concern in why you might want to be cautious about with dividend-investing as your strategy — you could lose your shirts.

IF YOU INVEST IN INDEX FUNDS, YOU WILL STILL GET DIVIDEND BENEFITS

If you make sure that you’re invested in the TOTAL return of an index fund, you can be sure that it includes dividends as well.

So you aren’t exactly losing out completely on dividend growth being around 40% of a return for a stock market. Y

ou just won’t be able to get the actual dollars from dividend-paying stocks into your pockets, enough to make it an income stream to live off.

HOW MUCH DO YOU NEED BEFORE YOU GET AN INCOME OF $40,000 A YEAR?

In one of the best cases, if you get stocks that pay out $2.88 a year per share, you need only13,888 stocks to achieve a gross income of $40,000 a year.

If those stocks cost about $60 each, you need about $833,280 saved as capital invested in these stocks before you can live off that income stream.

Not impossible, but it isn’t doable from the start. In fact, you probably won’t reach this goal until you’re in your 40s or 50s, and that’s with some steady saving and buying.

By the time you have that amount of money saved, maybe you’re already close to retirement, but $40,000 in 30 years may not be enough because of inflation eroding the purchasing power of your dollar. These are all things you have to take into consideration — could you do it?

YOU MAY HAVE MADE MORE MONEY IN INDEX FUNDS IN THE MEANTIME

On top of all that, the stock market itself as a while, while you had your money invested in 13,888 of these stocks, your return was 4.8%.

If you had invested that money in index funds (or the general stock market), it may have returned more than 4.8%, as an average of 7% over the year.

By chasing down actual dividends as an income, you would have lost out on 2.2% on your savings. It is one of those things that you can’t rush into, but it’s also one of those things that could pay off handsomely if done right.

HOW TO PICK DIVIDEND-PAYING STOCKS

A dividend-investing strategy is not as simple as picking a company that pays out dividends and calling it a day.

You can start by filtering down which stocks meet your criterion for dividends such as:

• Dividend Yield
• Dividend Growth
• Dividend Payout Ratio

DIVIDEND YIELD

You want to know how much money the company is paying out per stock, because after all, you’re looking at a stock mostly for its dividends.

You can find the calculation on almost any finance site for the stock, or do it yourself:

$2.88 paid out each year.

If the stock costs $60, then it’s:

$2.88 / $60 = 4.8% — which is your dividend yield

DIVIDEND GROWTH

You want to know whether or not this particular dividend payout will increase over time, by looking at the history of the company’s dividend-sharing.

I like to look at about 5-10 years of them consistently paying out dividends, and also consistently INCREASING the money they’re paying out, even by a penny.

If you go to any company’s website, they always have an Investor Relations page, where you can click on Dividends and see their history of what they’ve paid out since they started.

DIVIDEND PAYOUT RATIO

You want to know if the company is giving you money in desperation to keep you interested, or if they can really keep this up with without going bankrupt.

Some companies use dividends as an attractive way to get you to invest in them, but you could be investing in a dud that will make you lose all your invested capital (the original amount of the stock) if you aren’t careful.

BUT WAIT, THERE’S MORE!!!!!!

(OMG we’re not done? Nope. Not by a long shot.)

OTHER COMPANY FACTORS

Buying a dividend-paying stock is not just about the dividend itself, it’s also about the company.

Even if all three of those criterion work out in your favour, you still have to evaluate the company itself by running ratios and evaluating the sustainability of this company.

You have to know if the company is investing its money properly, growing over time so you can consistently earn dividends, or whether they’ll be able to increase dividend payout in the future.

You’re not going to be happy with a $0.12 return each year. You don’t want to overpay for a stock that is not worth it, just because of a few pennies in dividends per share.

DON’T FORGET ABOUT DIVERSIFICATION

You will also want to check to make sure that you aren’t putting all your eggs into one basket by choosing all technology stocks, all in banking, or all consumer goods stocks.

Pick one great company in each area that pays dividends so that if one industry tanks, another will go up to compensate.

WHAT TO DO WITH YOUR DIVIDENDS AFTERWARDS

You have an option of re-investing dividends back into buying more stocks, or you can just take the dividends as an income (and pay an income tax on it of course).

Questrade for instance, has a little checkbox on their forms that asks you whether or not you want to take any dividends as income, or if you want it re-invested back into stocks.

If you don’t bother to look at this checkbox, I believe the default answer is they’ll save up those dividends and re-invest them back into the company for you.

This action of re-purchasing share with dividend money is also referred to as a “DRIP” or a “Dividend Reinvestment Program”, which some companies offer for free, but others might charge you for it.

The awesome news about setting up a DRIP, is you don’t have to pay any brokerage fees to continue buying more stock in that company.

If you’re interested in how to set up DRIPs as a Canadian investor, I suggest reading this post over at Boomer & Echo.

DON’T BE AFRAID TO LEAVE

Yes, it’s all very sexy and comforting that you can build an income each month based on the stocks you hold, but don’t be afraid to get out when the getting is good.

You have to be vigilant with this dividend-paying stock strategy, because you have to do your research and make sure they’re a good, solid pick.

You have to continually check up on them to make sure you don’t lose your entire invested capital, just because of a few pennies.

OH AND ONE LAST THING..YOU CAN ALSO DO IT ALL WITH A MUTUAL FUND OR ETF!

If none of the above makes you jump for joy because of the work involved, consider buying dividend-paying mutual funds or ETFs instead.

Read: What is the difference between mutual funds and ETFs?

😉 Thought I’d forget about my favourite way of diversifying and investing in what I want all in one shot?

You can ALSO get dividend-paying stocks, all beautifully diversified if you are willing to pay for a mutual fund or ETF that is focused on dividends.

Some to look at for Canadians (these ETFs are also offered for Americans, but you might want to look at U.S. dividend-paying stocks), ranked in order of lowest to highest MER costs:

• FTSE Vanguard Canadian High Dividend Yield Index ETF (VDY) (MER = 0.30%)
• XHD – iShares U.S. High Dividend Equity Index Fund (CAD-Hedged) (MER = 0.30%)
• XDV – iShares Dow Jones Canada Select Dividend Index Fund (MER = 0.50%)
• CUD – iShares S&P US Dividend Growers Index Fund (CAD-Hedged) (MER = 0.60%)

Do your research, as usual, but this time, it’s less than what you’d be used to.

TAXES ON BUYING U.S. DIVIDEND-PAYING STOCKS AS A CANADIAN INVESTOR

For instance, even if you are a Canadian investor, keep in mind that when you buy U.S. stocks that pay out dividends, the U.S. government snatches their 15% as a withholding tax before you get to see any of it.

This is not because they hate our sweet maple syrup reserves, but it’s more that they (probably) assume all dividend-recipients of U.S. corporations, are U.S. citizens, who are obligated to prepay their taxes.

The only way to avoid that 15% American dividend tax as a Canadian is if you hold dividend-paying stocks in your RRSP or your RRIF, and the U.S. won’t take a withholding tax in the first place.

This is all applicable under the U.S.-Canada Tax Treaty which can be located here in Article XX1 paragraph 2(a). TFSAs, are not recognized under this U.S.-Canada Tax treaty, and are treated like un-sheltered or non-registered investments in the U.S. government’s eyes, but you can recover the tax you pay on those dividends with a withholding tax credit using form T2036 Provincial or Territorial Tax Credit. You can read more about that here.

If you receive dividend income from Canadian corporations, you get a dividend tax credit, and are taxed less than if it was considered interest income or dividends from foreign corporations (like U.S. ones).

Finally, if you die and have U.S.-based corporation stock as part of your portfolio, you will have to pay a U.S. estate tax. Read this.

So in short, if you decide to go the dividend-investing route with U.S. and Canadian corporations, you should hold dividend-paying stocks from the U.S. in your RRSP, and your Canadian dividend-paying stocks (or any stock you plan on making a profit on) outside of your RRSP.

You can read all about the tax implications and other details on how dividends are treated here.

SUMMARY

• Dividends are cash that is paid out to shareholders by the company on a regular basis
• Dividends are a great idea to have income coming in as part of your overall portfolio
• Dividends are like a re-distribution of shareholder wealth in a way
• Even after choosing stock that pays good dividends, you still have to choose the company!
• Don’t forget about diversifying your investments; so don’t put all your money into one stock
• Dividends can be re-invested to buy more company shares, called a “DRIP”
• You will have to always pay tax on any foreign dividends