Dividend investing is a way for investors to generate income from equities but it can also be used to create and enhance long-term capital growth and absolute returns.
How to invest in dividends
Dividend investments should be diversified so you don’t have all your eggs in one basket, you should also consider dividend-paying ETFs that track stocks or indices with a large number of dividend-paying components. Dividend income is subject to tax so it may be worth considering using stocks and shares ISA or SIPP provider as tax-efficient wrappers for your dividend investing.
What are dividends?
Dividends are the share of a company’s profits that are paid to ordinary shareholders. They are the reward that equity investors receive for taking the most risk within a company’s capital structure.
Dividends are a reward for risk-taking.
Dividends usually come in the form of cash, which is paid to the shareholders on the company’s share register, on a given date. Dividends are typically paid semi-annually or quarterly, though companies may also declare special dividends at other times of the year.
These may occur for example, if a company makes a lucrative disposal and wishes to distribute the profits from that sale to its shareholders.
Why dividend yields are important
When we talk about dividends we often use phrases like dividend yield, the dividend yield is simply a comparative measure, which is calculated by dividing dividends paid by the current share price. Such that a company with a share price of £1.00 paying dividends of 10p per annum has a dividend yield of 10%.
Knowing a company’s dividend yield means we can compare that yield to those of other dividend-paying shares, income-producing securities and asset classes, to make a judgment about valuations and the merits of a potential investment.
Five questions to ask when looking at dividend yields:
- How certain is the dividend stream? Rank the firm’s business model -> High/Med/Low.
- Is the firm profitable? If the firm is making losses, is it temporary?
- Is the whole sector down or just that stock?
- Is the firm borrowing to pay the dividends or it comes from the firm’s free cash flow? Choose the latter.
- Is the stock prices basing? Make sure the technicals look right
How dividends compare to other types of company ownership
Unlike secured bond or preference shareholders, equity investors, the ordinary shareholders in a company, have no claim on the assets of that business. And, in the event of bankruptcy, they are last on the list of unsecured creditors, to receive a payout.
In fact, the ordinary shareholders, or equity investors, in a company have really just bought into the “idea” of the enterprise, its ability to execute a business plan, and the goodwill that it generates in doing so. None of which is tangible, in the way a factory or plant is.
The equity within a business can be thought of as the excess value, over and above the tangible assets, cash and investments, within that business.
Owning income-producing assets such as dividend-paying shares is seen by many as being the cornerstone of wealth creation.
How can you invest in dividends in the UK?
The UK equity markets have a well-established track record of dividend payments and a history of dividend investing. Most members of the FTSE 100 index and many stocks in the FTSE 250 index are dividend-paying companies.
Dividend investing is synonymous with the desire to generate income through dividend yield. The current dividend yield for the FTSE 100 index (at the time of writing) is 3.72%. Meaning that for every £1000 invested in the index you could expect to receive £37.20 in dividends, or income, annually. Of course, you can’t invest directly in the FTSE 100 index itself. Instead, investors need to use proxies for the index, such as the shares within it, or funds that track it.
- What to invest in dividends? Compare best investment platforms in the UK here
Highest-paying FTSE UK dividend stocks
If you want to generate a similar dividend yield to the FTSE 100 you can invest in the top ten dividend-paying shares within the index.
The best UK dividend stocks are:
- Vodafone (VOD) 10.83%
- M&G (MNG) 10.48%
- Phoenix Group Holdings (PHNX) 10.00%
- British American Tobacco (BATS) 9.28%
- Legal & General Group (LGEN) 8.93%
- Abrdn (ABDN) 8.80%
- Taylor Wimpey (TW.) 8.41%
- Aviva (AV.) 8.34%
- Barrett Developments (BDEV) 8.19%
- Imperial Brands (IMB) 8.10%
Many of which have a dividend yield above the average for the index as a whole.
Dividend paying ETFs
Alternatively, you can buy into an ETF that tracks the FTSE 100, such as ISF, the iShares Core FTSE 100 UCITS ETF.
The fund aims to mirror the performance of the FTSE 100 index by owning a weighted basket of the stocks that comprise the UK Equity benchmark. By virtue of owning this basket of stocks, the ETF collects their dividends, which it distributes to investors in the fund every quarter.
Note though, that income investors need to ensure they buy the distribution version of ISF and not the dollar-hedged accumulation variant of the fund.
As a dividend investor you needn’t confine yourself to the FTSE 100 though. There are specialist dividend-focused ETFs, such as the US Bank State Street manages the SPDR S&P UK Dividend Aristocrats ETF, which invests in 39 UK companies with a long-term history of stable and growing dividends.
Nor do you need to limit your investment horizons to UK shores, fund manager Vanguard offers the Vanguard FTSE All-World High Dividend Yield UCITS ETF which aims to create well-diversified investment income, by holding a large basket of globally focused dividend-paying stocks.
What are the pros of dividend investing
The pros of dividend investing are essentially two-fold:
Firstly dividend investing can generate income in excess of what can currently be achieved through savings accounts, bank deposits and even the yields on 10-year govt bonds.
Which is good news for those looking to generate a cash return from their investments.
The temptation might be to invest in just a few high-quality, dividend-paying stocks, though prudence and risk management norms suggest that one should diversify a dividend or income portfolio, in the same way, that you would, if you aiming to generate capital growth.
Dividend investing can, however, also be used to generate or enhance capital growth through the reinvestment of dividends back into a portfolio.
If you take our example from earlier of a stock priced at £1.00 per share, paying a 10p, or 10.0% dividend per annum. You can see that after 10 years of dividend payments, at that level, the original investment would effectively have been paid for, by the income generated from it.
However, if that income was re-invested back into the stock over that time frame, you could, in theory, have also doubled you holding in it.
In fact, it’s possible that you holding would be even larger because you would have also benefited from compounding.
Imagine you own 100 shares in this company, in year two your original holding of 100 shares in the compnay would have grown to 110 shares, after reinvestment of the dividends into the stock, and you now receive dividends on the 110 shares in year three and so on.
Over the longer-term reinvestment of dividends and the compounding effects that it creates can generate significant outperformance.
For example, research by Hartford Funds finds that between 1960 and 2022 as much as 84% of the total return of the S&P 500 index, was generated by dividend reinvestment, rather than price appreciation.
Meaning that a notional $10,000 invested in the index in 1960, without dividend reinvestment would have grown to $795,000 by 2022.
Whilst the same $10,000 invested in the S&P 500, but this time with dividends reinvested, would have grown to be worth $4.95 million.
Where is the downside of investing in dividends
One of the main downsides to dividend investing can be fluctuations in or cessation of dividend payments.
Dividends are discretionary, not mandatory, and companies can choose not to pay them, and indeed some never will. For example, growth companies which are focused on expanding their businesses, rather than rewarding shareholders, don’t typically pay dividends at all.
The economy and business ecosystems are cyclical, that is they move in waves or cycles from good times to bad and back again. As the fortunes of companies move up and down within those cycles, their ability to pay and maintain dividends can vary significantly.
Dividend payments are largely a function of profitability, and profits that are in excess of costs. If companies are not making profits and accruing cash, then they are less able or willing to make distributions to their shareholders.
This can be particularly true in capital-intensive industries such as house building and oil and gas production. Both of these require significant investment and working capital, and both industries are highly sensitive to changes in the macroeconomic background, and factors such as demand and interest rates.
During a downturn, companies may choose to pay dividends from reserves of cash they have on hand, but that can only ever really be a temporary solution.
An obvious example of pitfalls of dividend investing and a lack of diversification can be found in the recent history of Lloyds Bank.
Lloyds had a history of stable earnings and a progressive dividend policy throughout the 1990s and early 2000s and it was a firm favourite among dividend and income investors at that time.
That was until the Global Financial Crisis of 2008. In the midst of this, Lloyds acquired its smaller rival HBOS, which turned out to be a financial black hole.
Lloyds would pay an interim dividend of 11.4p pence that summer, but it would be six years before it returned to the dividend list, with a final dividend payment, in 2014, of 0.75p per share.
Lloyds shareholders not only went without dividends for years, but they also lost the majority of their investment as the Bank’s share price collapsed.
A high dividend yield can often make a stock look attractive, but if it’s way out of line with its peer group, at a sector and index level, then that may be a red flag. And could signal that the market doesn’t believe that the dividend is sustainable.
Dividend investors can use metrics such as dividend cover and the dividend payout ratio to examine whether the dividend is viable.
Dividend cover is a measure of how many times a company could pay its proposed dividend, out of its existing reserves. Whilst the payout ratio shows what proportion of its net income, a company pays away in dividends.
The higher the dividend cover and the lower the payout ratio, then the more sustainable a dividend is thought to be.
Three Principles To Follow For Dividend Yield Investing
- Diversify – Buy a portfolio of stocks in different sectors/market capitalisation/earnings geography. This lowers the risk.
- Best-In-Class – Do not just look at headline dividend yields. Find the best stock in that sector that offers a good yield. They may pay less but could be financially stronger. During the 2008 crisis, Warren Buffett did not buy indiscriminately. He bought only the best (Goldman, GE, etc)
- Timing – Buy when the market is very fearful. This way, you are paying less to own the company.
When looking for sustainable and growing dividends investors often seek out what are known as dividend aristocrats. These are stocks with a track record of continuous dividend payments and dividend growth.
Definitions of what exactly constitutes a dividend aristocrat vary, but for ratings agency and index group S&P, a dividend aristocrat is a stock which has a 25-year (or longer) track record of dividend payment and dividend growth. In the US, there are currently 64 stocks in the S&P 500 index that meet these criteria including these top ten paying dividend aristocrat stocks:
|Aristocrat dividend stock
|Dividend stock sector
|Dividend growth in years
|Dividend yield as of the start of 2022
|International Business Machines Corp. (IBM)
|AbbVie Inc. (ABBV)
|Realty Income Corp. (O)
|ExxonMobil Corp. (XOM)
|Amcor PLC (AMCR)
|Chevron Corp. (CVX)
|Walgreens Boots Alliance Inc. (WBA)
|3M Co. (MMM)
|Consolidated Edison Inc. (ED)
|Franklin Resources Inc. (BEN)
In recent times with the rise of ESG (Ethical Social and Governance), some dividend investors have found themselves conflicted because many large dividend-paying stocks are in industries such as petrochemicals, mining, tobacco and defence. Which are not seen as being ethically or environmentally sensitive and that’s a circle that may become increasingly harder to square.