The Rewards of Investing in Quality Dividend Companies

— -- Investing in stocks that pay dividends is a time-honored strategy, and for good reason. It’s a great way to capture regular income in the form of dividend checks while benefiting from share-price appreciation.

The case for dividend stocks to power your portfolio is convincing. A study by Morgan Stanley’s Adam Parker showed that from 1930 through 2012, dividends accounted for 41.8 percent of total return of the S&P 500.

Dividends are payments companies send to shareholders. These payments come from net profits, and are often made quarterly, but some companies pay them monthly or annually.

Depending on the circumstances, you may be able to receive your dividends either as cash or as reinvestments in additional shares. Both methods have pluses.

If you’re looking for income from your investments, cash dividends are highly desirable. This can be particularly helpful in a bear market, because you don’t have to liquidate investments at a bad time.

Also, dividends are relatively tax-friendly for investment income. For most people, the tax rate for most dividends is 15 percent.

Investors typically have the option of getting dividends in the form of shares, which can propel highly beneficial compounding of your initial investment. As you will have to pay tax on dividends, it’s important to keep track of the shares you acquire this way so you don’t inadvertently pay double tax on them. For example, suppose you buy $1,000 of a stock and then receive $100 in dividends that you reinvest in the same stock. This $100 gain is taxable in the year that you received it. If you don’t remember this tax payment and sell your $1,100 in stock the following year, you might mistakenly pay tax again on the $100 gain. Brokerages account for this. If you’re handling these issues yourself, you must pay close attention to avoid this common error.

Though much has been written and said about owning shares of dividend-paying companies, many investors are unaware of nuances that can make a significant difference in the effectiveness of their dividend strategy. The key to keep in mind is the quality of the dividends that a given company may pay. Here are some points to consider:

• 1. Don’t be distracted from the goal of sound investing solely by the shiny object of a high recent dividend. Dividend payouts can seem large when a company’s shares have collapsed. What’s more important than the amount the board elected to pay, is how likely it is to continue. One of the best ways to gauge this is to take a close look at the company’s dividend history. Has the company regularly and reliably paid dividends? Or does it sometimes skip a year? You want companies that have paid dividends consistently for dozens of years –- or, if they haven’t been around that long, for most of their existence.
• 2. Patterns count. Has the dividend consistently increased or remained flat? Not only do flat dividends or, worse yet, years with no dividends mean less income for investors, but this scenario usually discourages investment and punishes share prices. That’s why boards should take care not to pay dividends too soon in their lifespan – when they still need cash to grow – and to avoid paying too much one year, requiring them to rein this in the next year, spooking investors. Many mature companies have raised dividends every year for 25 years or more; this is a standard of dividend reliability.
• 3. Avoid comparing dividend amounts in a vacuum. Look for dividends that reflect growth and strength, rather than those that are a strain on a company that perhaps shouldn’t be paying a high dividend. Say you’re considering buying two stocks in the same industry with similar growth projections. One recently paid a 5 percent dividend and other, 3 percent. But the 5 percent payer has a net profit of 5.5 percent and the 3 percent payer, a net profit of 12 percent, clearly indicating a greater potential for share price growth and sustained dividends. What’s more, this company may be reinvesting a greater proportion of its superior earnings in ways that will benefit shareholders down the road. So the issue of which stock to buy can have little to do with dividend rates alone. The dividends they pay relative to earnings, considered along with the need to fund business strategies, is worth examining.

Companies that pay dividends regularly and reliably tend to be large and mature. But there are also many small and mid-size companies that have histories of good dividend payments –- though these histories don’t tend to be as long as those of larger companies. So it’s possible to put together a well-balanced portfolio of different size companies –- in different industries -– that are good dividend payers.

Pursuing dividend companies is often a good idea. But investors should always look for quality dividends as a sign of companies that are desirable to own for many other reasons. By purchasing quality dividend companies, you can position for growth in value through long-term appreciation while reaping the incremental rewards of dividend income or additional shares along the way.

Any opinions expressed in this column are solely those of the authors.

Jamie Cornehlsen and Ted Schwartz are advisors with Capstone Investment Financial Group in Colorado Springs, Colo. Cornehlsen is also president of Dunn Warren Investment Advisors in Greenwood Village, Colo. A Certified Financial Planner®, Schwartz advises individuals and endowments. He holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com. Cornehlsen, a Chartered Financial Analyst®, advises business owners and employees on retirement plans. He holds a B.A. from the University of Colorado and an M.B.A. from the William E. Simon School of Business at the University of Rochester. He can be reached at jcornehlsen@capstoneinvest.com.