Monday, November 3, 2008

Dividend Stocks: Why you should own them!

For the past month or so, the financial media including dear ol' moi has been harping on the virtues of snagging some good dividend stocks while the pickings are ripe. The market is still on shaky ground and if the presidential election and the G20 meeting don't upset the applecart, chances are good we'll see a rebound (especially if the VIX can break its support level at 52). This means that now is the time to make a shopping list of stocks that pay a healthy dividend.

But what comprises a “good” dividend stock and why should you buy them now?

The case for owning dividend paying stocks
Did you know that stock dividends accounted for 42% of stock market gains over the past 90 years? According to a study by Ned Davis Research, dividend paying stocks increased 10.2% per year since 1972 while non-dividend stocks increased a relatively measly 4.4%. Inflation alone was about 4%. Also, dividend stocks in general are about half as volatile as their non-dividend counterparts. This means that although they won't rise as fast, they won't fall as fast, either, providing you with a bit of a cushion in bear markets (See reference below for full details on why you should own dividend paying stocks.)

Timing is critical to dividend yields
You want to pick up good dividend paying stocks when their prices are low.
Why? Because your dividend yield is increased. Remember that the dividend yield is the annual dividend divided by the stock price, so a lower stock price will increase the yield (assuming the dividend remains the same). For example, if a $100 stock pays a quarterly dividend of 50 cents, the dividend yield is 2% (((4x$0.50)/$100)x100%). But if that same stock loses half of its value, the dividend yield doubles to 4%. This effect becomes much more pronounced with lower priced stocks. One important thing to note is that even if your stock rises in price, your yield is locked in since it's tied to the purchase price.

Dividend reinvestment
Most (if not all) brokerage firms will let you specify if you'd like your dividends payed in cash or reinvested in the company stock. The answer to this depends on your age and circumstances. People at or near retirement may elect to take the cash while others might prefer the other option. If you're still young enough and don't need the income, I strongly advise reinvesting because it will not only increase your position size but the size of your dividend payout. The great thing about automatic dividend reinvestment is that there's no commission fee on the transaction. And speaking of commission costs, many companies will let you purchase stock directly through their DRIP programs (Dividend Re-Investment Plan) at no extra cost. The downside is that you won't have all of your holdings in one place which may not be worth the hassle especially if your commission fees are small.

Tax considerations
Dividends are taxed at the 15% rate which is lower than the capital gains rate (but that may not last depending on the outcome of tomorrow's election). Buying dividend paying stocks makes good sense in a retirement account. Some investments such as dividends from REITS (real estate investment trusts) may not fall under this special tax rate. Check with your accountant for further details.

I hope you see the benefits of owning dividend stocks. In the next few days, I'll be going through several recipes on how to find beaten down dividend payers and toss in my B O B (best of breed) recommendations from each group. This miniseries is sure to be worth your while.

Article: The secret to boosting portfolio performance by 42%, by Donald Moine, 2006. USA Asset Management.