Investing for dividends with verifiable undervaluation in the stock value is as close to holy grail of investing as you can get. Dividends are indeed a value investor’s best friend.
Value investing is the strategy stock market investors use to discover, validate and invest in different publically listed companies. The whole strategy revolves around finding stocks investors believe to be “undervalued”, by comparing a stock’s share price to what its “true” value is.
What some value investors focus on, to the exclusion of everything else, is finding that gap between a stock’s intrinsic value and its listed price.
That’s all well and good, but sometimes you have to step outside of yourself and gain some perspective. Even Benjamin Graham, known as the father of value investing, is on record saying that every company a value investor puts money into should have a lengthy track record of continuous dividend payments. At the same time, investing for dividends should not become a primary strategy to the exclusion of value.
Investing for Dividends Helps Anchor the Value in a Stock
In his book The Intelligent Investor, Graham is described as a researcher who goes into “molecular detail” on a specific company. Graham scoured through the reports of an oil pipeline company called Northern Pipe Line and found that, by his estimation, they were trading for $15 below their intrinsic value. He purchased stock in the company and badgered the management into raising the dividend in order to juice his return. He nearly doubled his money inside three years.
In chapter 5 of The Intelligent Investor, Graham lays out four rules for the selection of common stocks in a defensive investor’s portfolio. Rule three clearly states that “each company should have a long record of continuous dividend payments”. In the book, it’s clear that dividends are regarded as extremely important and that an investor should insist on investing in companies with 10 to 20 years of dividend history.
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Dividends are a sign of quality
It may seem crazy to a value investor to insist on 20 years of dividend history. How many stocks would that even leave? In Graham’s book, the author suggests that there would be around 200 companies to invest in after applying the criteria.
The biggest reason an investor would want this track record of dividend payments is to verify the quality of a company you’re investing in. Twenty years of payments is hard to fake, and you can rest easy that the business is generating real earnings and cash flow.
Many investors also tout the benefits of investing in a group of companies that are known for increasing their dividend year after year. This is an extremely attractive proposition for any investor and signals that the management is both shareholder-friendly and adept at allocating capital.
Sometimes companies will do this to protect their reputation. They know that investors value dividends very highly and a missed dividend could negatively affect their share price, so they will do everything in their power to meet the payment.
Proceed with caution. It is best when dividends come from profits, not borrowed money. Pay attention to book valuations
Dividends Matter: Dividends contribute greatly to your overall return
It’s hard to overstate the importance of dividends to an investor’s overall return. According to Bloomberg, dividends have accounted for almost half of the total return of the S&P 500 over the last 25 years. Between 1989 and 2014, the S&P 500 Total Return Index (reinvests dividends) gained 874% vs 469% for the simple S&P 500 Index.
In other words, if you ignored dividend paying companies you’re leaving half of your gains on the table. The choice between investing in a company that offers dividends and one that doesn’t is a bit like the decision to purchase just one-half of a pair of Converse sneakers; why even bother?
Dividends offer regular income
Sometimes being a value investor can be a thankless task. You do your research, identify a company that is undervalued and you make your purchase.
Then you wait.
It could take many years for the market to catch up to what the value investor knows to be true: the stock is undervalued. What makes that wait easier, is receiving income along the way.
That’s precisely why combining value investing with dividend investing makes sense. An investor who buys a value stock offering a dividend is essentially getting paid to wait for the market to realize the stock’s intrinsic value.
There’s a term for when an investor buys into a stock because it appears to be trading at a discount, and the stock price never appreciates. It’s called a value trap, so-called because the stock appears to be an attractive play, but then the investor becomes ever confused and entrenched as the stock goes nowhere.
At least when one combines value stocks and investing for dividends, an evaluation can be made once all or some substantial part of the investor’s capital is recovered. Either ditch the stock or keep holding, but you can rest easy knowing you’ve made something on the deal.
Adding another string to your bow
It should be clear by now that evaluating a company holistically involves a careful examination of its dividend payout history. Dividends are extremely important, both in mitigating risk and increasing returns, and any value investor would benefit greatly from incorporating this approach into their toolkit.
Therefore, for any investor attempting to calculate intrinsic value, it’s worth understanding the dividend discount model of valuing stocks.
The dividend discount model is a discounted cash-flow model. Basically you estimate the price of a stock by projecting all the future dividends that a company will pay out, add them up and discount them back to the present-day. If that number is higher than the price of the stock today then the business is undervalued and you should buy it.
You can get as sophisticated as you want with this model, incorporating dividend growth rates if one is so inclined, but the basic idea remains the same. A stock is the sum of all future payments discounted to the present day.
Dividend investing does not exist separately from value investing. They can be combined and arguably, you may be better off for it.
Graham, Benjamin, 1894-1976. The Intelligent Investor: a Book of Practical Counsel. New York :Harper, 1959. Web.
Johnson, Adam. “Show Me the Money: Why Dividends Matter.” Bloomberg.com. Bloomberg, 10 Sept. 2014. Web. 14 May 2017.
Staff, Investopedia. “Dividend Discount Model – DDM.” Investopedia. N.p., 13 Jan. 2015. Web. 14 May 2017.Jiva Kalan is a writer whose work has been featured on DailyFinance, the Wall Street Survivor, Plousio and Financial Choice.