Author: Susie Q

Mutual Funds and ETFs

Mutual Funds and ETFs

Mutual fund and ETFs (exchange-traded funds) allow you to invest in securities without having to select individual positions. Instead, the fund manager makes the decisions as to when to buy and sell each security. As such, a fund is an easy way for new or 

How to Raise Financially Smart Kids

How to Raise Financially Smart Kids

I wrote a guest post for Grokking Money about how to raise financially smart kids.  Here is the start of it, to read the entire post, click here. Instilling your children with good financial habits will increase their likelihood of success, just as is the 

Do I Really Need to Budget

Do I Really Need to Budget

I wrote a guest post for The Smart Investor about deciding if you need a budget.  Here is the start of it, to read the entire post, click here.

Budgeting is critical to your financial health, especially when you are just getting started handling your own money.  A budget will help you figure out whether you can afford to make big purchases – a car, a home – whether you can afford a nice vacation and whether you need to find a way to make more money.  However, not everyone needs to make and stick to a budget.

In this post, I’ll talk about the characteristics of people who will benefit most and least from making a budget and will provide a questionnaire you can use to help figure out . . . Read More

Good Debt vs Bad Debt: Key Characteristics

Good Debt vs Bad Debt: Key Characteristics

Not all debt is bad! The specific definitions of good debt vs bad debt will vary from person to person. For people who plan to retire very early and live on a limited income or for people who know that they have a hard time 

Picking Stocks

Picking Stocks

Many investors create their own portfolios by picking stocks in individual companies. As discussed in my post on the basics of stocks, picking stocks in individual companies is one of several strategies for creating an investment portfolio. Alternatives to picking stocks in individual companies include 

Investing for Dividends

Investing for Dividends

Investing for dividends is one of many strategies investors use to identify stocks for their portfolios. Among the strategies I identified in my post on what you need to know about stocks, this is not one that I have ever used.  So I reached out to one of my Twitter followers who uses it to get more information, Dividend Diplomats (aka Lanny and Bert) to get some real-life insights. With Lanny’s and Bert’s help, I will:

  • define dividends.
  • talk about the criteria that Lanny and Bert use for selecting companies and why they are important.
  • show some historical returns for dividend-issuing companies.
  • explain the tax implications of dividends on your total return.

What are Dividends?

A dividend is a cash distribution from a company to its shareholders. The amount of the dividend is stated on a per-share basis.  The amount of cash you receive is equal to the number of shares you own times the amount of the dividend. When companies announce that they are going to pay a dividend, they provide two dates.  The first is the date on which share ownership is determined (also known as the ex-dividend date).  The second is the date on which the dividend will be paid. For example, a company might declare a 15₵ dividend to people who own shares on May 1 payable on May 15. Even if you sell your stock between May 1 and May 15, you will get 15₵ for every share you owned on May 1.

When a company earns a profit, it has two choices for what to do with the profit. Under one option, the company can keep the profit and use it to support future operations. For example, the company might buy more equipment to allow it to increase the number of products is makes or might buy another company to expand its operations. Under the second option, the company distributes some or all of its profit to shareholders as dividends. My experience is that companies that are growing rapidly tend to keep their profits, whereas companies that can’t find enough opportunities to reinvest their profits to fund growth tend to issue dividends.

Dividend Diplomats – A Little Background

Lanny and Bert have been blogging for over 5.5 years and have been best friends for 7.  They both are pursuing the same goal of reaching financial freedom and retiring early to break the “9 to 5” chains.  They hope to achieve financial freedom through dividend investing, frugal living, and using as many “personal finance” hacks as possible to keep expenses low and bring in additional income. For more information about the Dividend Diplomats, check out their web site at www.dividenddiplomats.com.

Why Use the Investing for Dividends Strategy

As you’ll see in future posts, I have used several strategies for my stock investments, but have never focused on investing for dividends.

My Preconceived Notions

I have always considered investing for dividends as most appropriate for people who need the cash to pay their living expenses, such as people who are retired. I am retired, but currently have cash and some bonds that I use to cover my living expenses. As I get further into retirement, I will need to start liquidating some of my stocks or start investing for dividends.

Lanny’s & Bert’s Motivation

So, when I started reading about Lanny and Bert, I wondered why people who are still working (and a lot younger than I am) would be interested in investing for dividends.   Here’s what they said.

“There were a few different motivating factors.

Lanny had endured a very difficult childhood, where money was always limited and his family had struggled financially.   Due to this, he personally wanted to never have to worry about money, period.

Bert was not a dividend growth investor until he met Lanny.  Once he talked to Lanny, learned about dividend investing, and saw the math, he was sold and hasn’t looked back since.

Therefore, we are looking to build a growing passive income stream so we can retire early and pursue our passions.  Building a stream of growing, truly passive dividend income has always been a very attractive option to us.  We love the fact that dividend income is truly passive (outside of initial capital, we don’t have to lift a finger) and we are building equity in great, established companies that have paid dividends throughout various economic cycles.

Second, the math just makes sense.  It is crazy how quickly your income stream grows when you are anticipating a dividend growth rate of 6%+ (on average).  Lanny writes an article each quarter showing the impact of dividend increases and we have demonstrated the impact of dividend reinvesting on our site in the past. When you see the math on paper, it is insane. “

Lanny and Bert provided links to a couple of their posts that illustrate the math: Impact of Dividend Increases and Power of Dividend Reinvesting.

Lanny’s & Bert’s Strategy

Lanny and Bert developed a dividend stock screener that helps them identify undervalued dividend growth stocks in which to consider investing.  At a minimum, the companies must pass three metrics to be further considered for investment:

  • Valuation (P/E Ratio) less than the market average.
  • Payout Ratio Less than 60%. (Unless the industry has a higher benchmarked figure. i.e. oil, tobacco, utilities, REITs, etc., then they compare to the industry payout ratio.)
  • History of increasing dividends.

They don’t consider dividend yield until later in the process.  They never advocate chasing dividend yield at the risk of dividend safety. That is, they would rather a dividend that has very low risk of being reduced or eliminated (i.e., safety) than a higher dividend be unsustainable over the long term.

That’s why they don’t look at yield initially.  It allows them to focus on the important metrics that help them gain comfort over the safety of the dividend.  Here is a link to their Dividend Stock Screener.

Payout Ratio

Lanny and Bert mention that that one of their key metrics is a payout ratio. A dividend payout ratio is the annual amount of a company’s dividend divided by its earnings per share.  For more about earnings per share, check out my post on reading financial statements.

A dividend payout ratio of less than 1 means that a company is retaining some of its earnings and distributing the rest. If the ratio is more than 1, it means that the company is earning less money than it is paying out in dividends.

I worked for a company that had a payout ratio of more than 1. When I first started working there, the company had more capital than it could use. The company was returning its excess capital to its shareholders through the high dividend. After several years, the company’s capital approached the amount it needed to support its business. If it had cut its dividend to an amount lower than its earnings, the stock price might have decreased significantly. Instead, the company was sold. Had the company not been sold, its shareholders might have had both a decrease in future dividend payments and a reduction in the value of their stock at the same time.  This double whammy (dividend cut at the same time as a price decrease) is a risk of owning a stock in a dividend-issuing company especially those with high dividend payout ratios.

Performance – Lanny and Bert’s View

Lanny and Bert are not assuming they can do better than management or the market.  As noted above, they tend to focus on companies with a dividend payout ratio less than 60%.  This approach allows for all three of increasing dividends to shareholders, share repurchases, and internal growth for profit.  Also, this approach ensures the company is continuing to invest in itself as well.  You can’t pay a dividend in the future if you can’t grow, or even maintain, your current earnings stream.  Therefore, if revenues are stagnant or shrinking, the safety of the company’s dividend comes into question.  Companies “can” pay out a dividend that is larger than your earnings over the short-to-medium term.  However, it is not sustainable as was the case with the company for which I worked.

Historical Performance

I was curious about how stocks that met Lanny and Bert’s criteria performed. I have a subscription to the ValueLine Analyzer Plus. It contains current and historical financial data and stock prices about hundreds of companies. I looked at two time periods.  I first looked at the most recent year (November 2018 to November 2019).  Because I was curious about how those stocks performed in the 2008 crash, I also looked at the ten-year period from 2003 to 2013. I would have used a shorter period around the 2008 crash and the period thereafter, but didn’t save the data in the right format so had to look at time periods for which I had saved the data in an accessible manner.

How I Measured Performance

For both time periods, I identified all stocks for which the data I needed for the analysis were available at both the beginning and end of the period.  There were 1,505 companies included in the sample in the 2018-2019 period and 952 companies for the 2003 to 2013 period.

I then identified companies (a) whose dividend grew in each of the previous two fiscal years, (b) whose dividend payout ratio was less than 60% and (c) whose P/B ratio was less than the average of all of the companies in the same. That is, I attempted to identify the companies that met Lanny and Bert’s criteria. There were 332 companies in the 2018-2019 period and 109 companies in the 2003-2013 period that met these criteria.

ValueLine ranks companies based on what it calls Timeliness, with companies with Timeliness ratings of 1 having the best expected performance and those having a rating of 5 having the worst expected performance. Because I suspected that Bert and Lanny’s screen would tend to select more companies with favorable Timeliness ratings than those with poorer ones, I looked at both the overall results, as well as the results by Timeliness rating.

November 2018 – November 2019

In the most recent year, the stocks that met Lanny’s and Bert’s criteria had an average total return (dividends plus change in stock price) of 11% as compared to 8.5% for the total sample. That is, in the current market, dividend issuing companies meeting their criteria returned more than the average of all companies.

Interestingly, when I stratified the companies by Timeliness rating, it showed that for companies with good Timeliness ratings (1 and 2), the Lanny’s and Bert’s companies underperformed the group. For companies with two of the three lower Timeliness ratings (3 and 5), though, Lanny’s and Bert’s companies not only did better than the average of all companies in the group, but also did better than even the group of companies with a Timeliness rating of 1! It looks to me as if their approach might identify some gems in what otherwise appear to be poorer performing companies.

The chart below shows these comparisons.

2019 total returns on dividends stocks by ValueLine TImeliness ranking

2003 to 2013

Over the longer time period from 2003 to 2013, the companies meeting Lanny’s and Bert’s criteria didn’t do quite as well as the average of all companies. In this case, the stocks meeting their criteria had a compound annual return of 5% as compared to 7% for all stocks in the sample. Without more data, it is hard to tell whether the difference in return is the sample of dividend-issuing companies is small, because those companies didn’t fare as well during the Great Recession or something else.

I looked at the total returns by Timeliness rating and the results were inconsistent for both the “all stocks” group and the ones that met our criteria. A lot can happen in 10 years! Nonetheless, it was interesting to see that the dividend-yielding stocks that had Timeliness ratings of 5 in 2003 out performed all other subsets of the data. So, while these stocks didn’t have quite as high a total return over the 10-year period in the aggregate, there are clearly some above-average performers within the group.

Tax Ramifications of Dividends

One of the drawbacks of investing in companies with dividends, as opposed to companies that reinvest their earnings for growth, is that you might need to pay taxes on the dividend income as it gets distributed.

Types of Accounts

If you hold your dividend-yielding stocks in a tax-deferred (e.g., Traditional IRA or 401(k) in the US or RRSP in Canada) or tax-free (e.g., Roth IRA or 401(k) in the US or TFSA in Canada), it doesn’t matter whether your returns are in the form of price appreciation or dividends. Your total return in each of those types of accounts gets taxed the same. That is, if you hold the stocks in a tax-deferred account, you will pay tax on your total returns, regardless of whether it is interest, dividends or appreciation, at your ordinary income tax rate. If you hold the stocks in a tax-free account, you won’t pay taxes on any returns.

The only type of account in which it matters whether your return is in the form of price appreciation or dividends is a taxable account. In the US, most people pay 15% Federal income tax plus some additional amount for state income taxes on dividends in the year in which they are issued. They pay taxes at the same rate on capital gains, but only when the stock is sold, not as the price changes from year to year. In Canada, the difference is even greater. Dividends are taxed at your ordinary income tax rate (i.e., they are added to your wages) and capital gains are taxed at 50% of your ordinary income tax rate and only when you sell the stock.

Dividend Reinvestment

When you earn dividends from a company, you often have the option to automatically reinvest the dividends in the same company’s stock. This process is a dividend reinvestment plan. Lanny and Bert take this approach.

Dividend reinvestment plans are terrific ways to make sure you stay invested in companies that you like, as you don’t have to remember to buy more stock when the dividend is reinvested. The drawback of dividend reinvestment plans is that you will owe tax on the amount of the dividend, even if you don’t receive it in cash. If you reinvest 100% of your dividends, you’ll need to have cash from some other source to pay the taxes unless you hold the investments in a tax-free or tax-deferred account.

Illustration

Let’s assume you are a US investor subject to the 15% Federal tax rate and pay no state income tax. You have two companies you are considering. You expect each to have a total return of 8%. One company’s return will be 100% in dividends, while the other company issues no dividends. You plan to own the stock for 10 years. Your initial investment will be $1,000 and you will pay your income taxes out of your dividends, so you reinvest 85% of the dividends you earn each year.

At the end of the 10th year, you will have $1,931 if you buy the company with 8% dividends. If you buy the company with no dividends, your stock will be worth $2,159. After you pay capital gains tax of $174, you will have $1,985 or 2.8% more than if you buy stock in the company that issues 8% dividends.

If you pay Canadian taxes, the difference is even bigger because of the much lower tax rate on capital gains than dividends. Over the full ten-year period, you will end up with almost 11% more if you buy stock in the company with no dividends than if you buy stock in the dividend-issuing company.

As such, you’ll want to put as much of your portfolio of dividend-issuing stocks in a tax-deferred or tax-free account as possible to minimize the impact of taxes on your total return.

Reading Financial Statements

Reading Financial Statements

Reading financial statement guides many investors in their decisions to buy and sell stocks.   Investors who focus on financial fundamentals look at recent financial statements in the context of other trends to estimate how much a company’s future profit might grow.  High-dividend yield investors need 

What You Need to Know About Stocks

What You Need to Know About Stocks

Stocks are a common choice for many investors.  There are two types of stocks – preferred and common.  Because most investors buy common stocks, they will be the subject of this post.  I’ll talk about what you need to know about stocks before you buy 

Recovery from Financial Disaster

Recovery from Financial Disaster

Ever wonder how you’d handle a complete reversal of your finances? I have a friend who had a lifestyle most people would envy and lost everything, including her marriage. I didn’t meet her until after her recovery from her financial disaster. She is one of the most resilient, generous people I know and was kind enough to let me interview her about the changes in her life, the financial lessons she learned and her advice to you on how to avoid finding yourself in a similar situation.

The High Life

“My life was very plentiful with many material objects.

  • 6,000+ square foot custom designed home – 6 bedrooms, 5 bathrooms and two full kitchens
  • Photography and recording studios
  • In ground swimming pool
  • Custom designed furniture
  • Six cars
  • Trips
  • Private education for both kids
  • Entertainment

I never priced groceries, just grab and dash.  We belonged to a private country club as well.  We also had an investment property that we rented to a family member.”

Tell Me about Your Finances

“I did not think of my financial future.  I was in my mid to late 40s and I thought the gravy train would never stop.  We had many investments, 401(k) and IRA retirement accounts for us as well as the children.  My husband was a very successful stock broker, financial planner and money management specialist. We had a dual income, and mine paid for the cream on the top.”

What Happened?

“The stock market along with the real estate market became very soft in 2007.  When I began to notice that these change were imminent, I suggested that we liquidate assets into a strong cash position.  My husband dismissed my thoughts on this topic because I had never been persistent in being a co-manager of our funds.  The economy was showing its ugly powerful head and so was our 40-year marriage.

Things went from bad to worse.  We lost our home. Instead of getting money from the buyer when we sold our house, we had to come to closing with a six-figure check to pay off the mortgage balance (because we owed more than we got for the house). Otherwise, we would have had to negotiate a short sale with the holders of the loan on the house to try to get them to accept only the amount for which we sold it, but chose to close in a traditional manner due to a prideful attitude that made no sense at all.

We divorced.  The money, the investments and the lifestyle were gone.  I was 59 years old. Our children were grown and gone.  Thank God they had their educations!”

What Did You Do?

“I moved into a house with five other people to secure a reasonable rent of $600 a month.  I rolled up my sleeves and decided to re-invent myself as a strong salesperson with a steady stream of income.  As part of creating a fiscally responsible lifestyle, I consolidated my debt and made a conscious effort to understand my taxes and my expenses.  These changes allowed me to pay off the tax liability for which I was half responsible after the divorce.”

What is Your Life like Now?

“My lifestyle now is very simple.

  • I use one credit card.
  • If I can’t afford something, I don’t buy it.
  • I shop at thrift stores, make curtains, paint, have learned some electrical skills and can do just about anything.

Having made the financial changes, I now have the opportunity to travel. I have investments and simple monthly debt. My credit score is very high and I am able to contribute to my savings account and an IRA on a regular basis.”

What Advice Do You Have?

“I learned these financial lessons that might help your readers:

  • Always know your cash position whether or not you are wealthy.
  • Have a good grasp on your finances.  Knowledge is power.
  • Cash is king.
  • Know your financial position at all times.
  • Stay away from credit cards and their incredible interest rates.
  • Save and keep adding to your retirement.”

Closing Thoughts from Susie Q

You’ll notice that my friend’s financial lessons learned are similar to themes you’ve seen in posts I’ve written, especially in the post on advice we gave our kids.

Her story, though, provides real-life insights into why these actions are so important.

You’d never know if you met my friend now that she had to make such a long recovery from financial disaster. She is always upbeat, willing to lend a hand and a great motivator. In fact, she contributed to the initial costs of this blog because she was so thrilled that I am willing to share my knowledge with others to help them be financially literate. I hope I am as resilient as she is if I ever face an equally daunting challenge.

Top Ten Posts in Our First Year

Top Ten Posts in Our First Year

Financial IQ by Susie Q celebrated its first birthday last week. In the first year, we published 52 posts on our site, two of which were guest posts from other authors, and published two posts on other blogs. In case you haven’t had time to