If you’ve ever invested in stocks, chances are you’ve heard of dividend investing. If you’re not familiar with how it all works, you can use this report as an introduction to dividend investing. Not only that, but I’ll show you how you can grow your portfolio too.
Many of the principles that apply to success in the stock market carry over to dividend investing too. You’re still investing in stocks — the only difference is that your focus is on buying shares in companies that consistently pay out dividends to shareholders.
If you’re nearing retirement, dividend investing could be another way to help secure your future financially. If you play it smart, it’s a strategy that can work for you over an extended period of time, growing your wealth well into retirement.
Dividend investing is a strategy for people that want sustainable — and stable — returns. It certainly isn’t a strategy that relies on volatile, short term movements in the market where the goal is chasing quick returns.
As with any investment, there are steps you can follow to try and make the most of your dividend investments. We’ll be taking a look at some of these strategies below. I hope you’ll come away from it with a better understanding of what successful dividend investing involves, and how you can use it to grow your wealth.
A few things to remember before starting out in dividend investing
It’s important you keep in mind that the purpose of this strategy is to maximise the dividend payouts for your portfolio. This means that your success is dependent on whether the board of a company decide to pay out dividends to shareholders. And not every board does.
There are valid reasons for this. Businesses may decide that holding onto cash might be more urgent than paying out dividends to shareholders, especially if the company posts poor yearly earnings.
Many boards aim to pay out dividends to shareholders because, in doing so, they are helping to attract new investors. The more dividends they pay out, the better the company’s position is in the eyes of investors.
When a company cuts dividends to retain cash holdings, it can give the market the impression that the company is in trouble. Often, you’ll see the share price take a tumble. For this reason, it’s worthwhile researching a company’s dividend payout history — too many dividend cuts aren’t going to improve your portfolio long term…
The first rule of successful dividend investing…select companies with good track records
When you’re investing in companies to generate returns from dividends, it pays to track their record. Companies that have been around seemingly forever are often seen as a ‘safe bet’. And you already know why that makes those companies desirable.
It’s because you know what you’re getting with these companies. These are businesses that may be in a stable industry that rarely undergoes disruptive change.
An example of this might be healthcare. Demand for healthcare is consistently stable, with access to medical care seen as a basic human right.
But they don’t have to be in slow changing industries to have a strong track record. If you find companies that have survived for decades in a fast changing industry, these could be equally good dividend investment opportunities.
Companies with good track records of consistent dividend payouts have proven that they can continue to provide investors with dividend returns, because they are confident in what they do as a business, and they do it well. Companies with a long history of good performances will do most of the work for you.
That’s a good thing, as changing your stock portfolio regularly leaves you open to both capital gains taxes — which you pay when you sell a stock for a profit — and any associated transaction fees. That leaves more of your shareholdings to appreciate with any rise in the company’s share price — which can result in higher dividend payouts for you over time.
Long term sustainability also implies that these businesses are likely to have an edge over their competitors. It suggests that there is something about these companies which makes them resilient in the face of market competition. In the case of Telstra [ASX:TLS], for example, that advantage could be something as simple as having the privilege of owning the vast majority of the nation’s communication infrastructure.
Not every company will have an obvious competitive advantage like Telstra. But in finding companies that do, you’ll go a long way in ensuring that your shareholdings pay a reliable and steady stream of dividends.
The second rule of successful dividend investing…pick companies that offer real value
Many investors look towards businesses that are booming. They see the share price making big gains, and they try and get in on the action. But in doing this, these investors might end up just chasing the market. And that’s not always the wisest move you can make.
It pays to look at businesses which are trading below their real value. Companies that have a product, or service, which is of real value and quality and are likely to prosper. Even if their stock looks underrated, the value of what they offer to their customers can often ensure that their stock stabilises over time.
But even companies that see a sharp decline in their share price could still be good investment opportunity. Every company needs to be judged on its merits. A lower share price could give you the opportunity to invest in these companies below their true value.
A company whose share price tumbles after an unforeseen incident may look like a bad investment at face value. But if you can see that what they provide will continue to stay in demand in the future, one incident alone doesn’t make the company a bad investment.
In fact, the best time to buy into a company is when their shares are undervalued. An investor needs to look at events that harm a company (or even an entire industry), and assess whether depreciating share prices reflect the overall value of the product and service they offer. If not, it could be a good time to buy into them while stocks are trading below real value.
The third rule of successful dividend investing…don’t diversify too much
It’s normal that, as an investor, you may feel the urge to spread your investments across a large range of stocks. But that might not always be the best strategy, because it could result in mediocre dividend returns. Stock market guru Warren Buffett recommends two different approaches for dividend shareholders in deciding how many companies to invest in.
First, you may want to consider putting your money into a select handful of companies that you’re really bullish on. These are companies with the longevity and track record of dividend payouts that you are confident will pay you money. The more confident you are in any one company’s ability to pay out high dividends, the more you could allocate in these stocks relative to other companies.
The second option is to select up to 20 companies to invest in. That way you could invest in the handful of businesses you believe will provide consistent dividends, while still leaving room for some riskier stocks. If the risky stocks don’t work out, you have your safer dividend stocks to fall back on.
If nothing else, diversifying your portfolio into 50 or 100 stocks isn’t recommended. That’s not a strategy; it’s hit and hope. It’s also very difficult to have an intimate knowledge of that many companies. And it will probably mean low dividend payouts, as the money you make from successful companies could be lost in a sea of mediocre companies that you end up losing money on.
The fourth rule of successful dividend investing…avoid companies with high dividend yields
You’d be wise to remain wary of any company which is offering dividend yields of over 10%, especially if the market ‘average’ is closer to 4.5%. It could be a sign the market thinks the company’s current payout ratio and/or dividends are unsustainable.
Remember that the yield is based on historical dividend payouts over the last 12 months as a percentage of the current share price. Just because a company has paid out a level of dividends in the past, it doesn’t mean that they will necessarily do so in the future. A falling share price could reflect the market’s expectation of lower dividends in the future.
It could also mean that the company is using debt to fund dividend payouts for shareholders — a practice known as dividend recapitalisation. Santos [ASX:STO], an Australian energy producer, announced at one point that it could resort to dividend recapitalisation after promising shareholders that dividends wouldn’t fall. However, sharply dropping oil prices meant that Santos did have to significantly reduce its dividend last year. And, just recently, even BHP Billiton [ASX:BHP], took the unpopular decision of lowering its dividend payout.
To avoid companies that use debt to fund dividend returns, it’s important to look at a company’s cash track record going back several years. You’ll often see this referred to as free cash flow. By doing this you can determine how much of the dividend has come from its own cash earnings.
The thing to remember here is that if the dividend payouts are regularly lower than the amount of cash flow a company has, it should tell you that they can continue to pay out dividends on a similar level consistently.
The fifth rule of successful dividend investing…pick companies with good management
This one might not come as any great surprise to you, but you should be on the lookout for companies that have strong management teams. These are the kind of management teams that can create wealth for you as a shareholder.
In the short term, it might be a bit difficult to know whether a company has good management. However, the longer back you go, the more evidence you’ll be able to see of consistent and strong results.
As a start, compare that company’s performance versus any of its peers over a five or 10 year period. And, similarly, see how the company has tracked in comparison to the market index. If you believe that the market always works out the truth, then the evidence should be there in the share price.
Observe which companies decide to buy back shares when their stocks are trading below value. This helps add shareholder wealth if share prices start to rise (as this reduces the number of shares on issue). This also shows you that management remain confident in their core business.
Another thing you should be wary of is companies that buy up other businesses outside their area of expertise or industry. That could be a sign that management is overreaching in order to grow the company.
Diversification can be a risky business, and it can take focus away from the core business. One recent example of this involved eBay Inc. [NASDAQ:EBAY], which wanted to expand its business in 2011 by purchasing the popular internet phone service Skype (now owned by Microsoft [NASDAQ:MSFT]). It didn’t turn out as expected, with eBay eventually selling Skype to Microsoft in order to revert back to its core business.
What are franking credits?
If you’ve invested in shares before, you probably don’t need an introduction to how franking credits work. But if you’re starting out as a dividend investor, or if you just want a bit of a recap, then it’s worth revisiting how franking credits work.
How franking credits prevent double taxing of company profits
The Hawke-Keating Labor government introduced franking credits in 1987 in a bid to prevent double taxing which had, up to then, effectively forced both companies and shareholders to pay tax on a company’s earnings.
Before the introduction of the law, company profits were taxed at the corporate rate of 30%. Investors, who then received their dividend payments from the after-tax profits, would pay an additional tax at their marginal income tax rate.
Prior to the introduction of the franking credits system, if you’d received a dividend payment from a company in which you owned shares, you had to pay tax on the full amount of the dividend. And it wouldn’t matter if the company had already paid corporate taxes on their profits. Your dividend earnings were regarded the same as any other income source you received during the year.
The 1987 law changed all that.
Today, investors only have to pay the difference between what a company pays in taxes (at the corporate tax rate of 30%), and their own marginal tax rate. For example, if your income tax rate is 30%, you wouldn’t have to pay any additional taxes on a fully franked dividend, because the company you hold shares in has already paid their 30% tax on profits.
For instance, if your income is taxed at 45% you’d be liable to pay the difference. That means you’d only pay a 15% tax on your dividend payouts, instead of the standard 45% tax rate for any other income.
The franking credits system allows investors to claim a tax credit that amounts to a corporate tax rate of 30%, providing the dividend is fully franked. This changes if the dividend is only partially franked.
To calculate how this benefits you, you start with the dividend amount. You then add the value of the franked amount to give you a ‘grossed up’ figure, which is then used as the base for the calculating the amount of tax payable.
You can see the immediate benefits of fully franked dividends as a shareholder, as it can reduce your tax liability if your marginal tax rate is 30% or lower.
In 2000, a revision to the law made franking credits fully refundable. For example, if you earned less than the tax-free income threshold, not only would you not pay any tax, but you could get franking credits back as a refund. That made the system an attractive investment strategy, especially for retirees that could manage the amount of income they earned during the year.
Then, in 2006, another change to the franking credits system allowed anyone over the age of 60 to earn income on their superannuation without paying tax on it. A retiree could structure their investments to ensure that little, or none, of their income was taxable. That would free them up to convert franking credits into cash at the end of the financial year.
What changes to the franking credits system could mean for you
Some claim that franking credits favour the wealthy too much and that investors are exploiting the current system. If you’ve seen some of the debate about fixing the budget deficits, you’ll know the government is looking for different ways to plug this hole — and they have the $30 billion franking credits system in their sights.
Under the current system, around $10 billion worth of franking credits goes to Australian households every year, with another $20 billion split between companies and superannuation funds.
One oft-mentioned tax break could free up an estimated $5 billion in the budget every year if the government canned it. Should this ever happen, it would be the biggest change to the dividend imputation system since 2006. However, any changes to the law would need to get through Parliament first, which may prove easier said than done.
The rule the government might look at abolishing would prevent investors, who have no tax obligations to offset against their franking credits, from receiving a cash payout from the Australian Taxation Office (ATO). The government says that this law costs the nation around $5 billion a year. And they’re pointing to the fact that no other country allows this practice as a reason to abolish it.
Currently, the wealthiest 10% of Australian households — those earning over $207,000 a year — get 75% of all franking credits that go to households. The National Centre for Social and Economic Modelling (NATSEM) have created models showing that the wealthiest 20% of households earn up to $8.3 billion in franking credits, while the poorest 20% get $164 million.
NATSEM say that, with 61% of superannuation funds held by the wealthiest 20% of households, the $10 billion that goes to super funds and charities also finds its way to the wealthiest households as well.
Why it could be bad news for you, especially if you have a self-managed super fund
If you’re one of the many Australian investors who rely on the franking credits system as an investment strategy for your portfolio, any amendments could put a hole in your retirement nest egg. The investors with the most to lose, should proposed changes turn to reality, are retirees, especially those with self-managed super funds (SMSFs).
If you have investment income in an SMSF, you’ll get taxed at 15% on that income prior to accessing your superannuation money. Once you qualify for an aged pension, the tax on your SMSF goes down to 0%.
For any income on your investments — such as dividend payouts — franking credits will offset the tax on those dividends, and you’d be in line to receive a cash payout from the ATO. That money goes straight into your pocket at the end of the year.
That’s why franking credits are so important to any successful dividend investment strategy. They help to maximise the returns on your investments. They won’t help you decide what stocks to pick, but franking credits can go a long way in helping you retain the wealth that you create from your investment strategy.
How to succeed as a dividend investor
You should always keep things simple if you want to succeed in dividend investing.
Remember to look out for companies with good management teams, and a strong track record in offering their customers real value through quality products or services. When you buy into these companies, be prepared to stay with them in the long run, letting them maximise your investment through consistent dividend payouts.
You should aim to diversify your portfolio to no more than 20 companies. In this way, you’ll ensure a certain level of stability with your dividend returns. And, finally, be careful of companies whose dividend yield is well above the market average.
If you follow these simple steps, you are on the way to making the most of your dividend investments.
Income Specialist, Money Morning