The Problem with Dividend Investing

Today, I’m reviewing an article written by Mr. Tako called “The Problem with Dividend Investing”.  If you want to read it, check it out here.

This is a well-written article with some really sound advice.  If you manage your own portfolio, this post is particularly applicable to you.

Here were my three main take aways:

#1: A Real-Life Example of Dividends = Financial Freedom

The author (“Mr. Tako”) lives entirely off of the income produced by his investment portfolio.  He is a real-life example of how dividend investing can be such a powerful strategy for achieving financial freedom without worrying about market ups and downs.

#2: There Is No Such Thing as Buy and Hold

A strong company today may not be the same in three years.

Your dividend portfolio is like a garden, you can’t just plant and forget it.  Your portfolio (and every stock in it) must be constantly monitored for deteriorating business fundamentals.  If you don’t pay attention, you could end up with a portfolio full of dividend cutters and/or stagnant businesses.

#3: Create a Dividend Checklist

In the best-selling book, “Checklist Manifesto”, the author (a medical doctor) recalls countless examples in all kinds of fields where a simple checklist can prevent mistakes.

Investing is no different.

A checklist can help you identify when one of your holdings might be getting weak and identify a potential sale candidate before it’s too late.  Mr. Tako generously shares his own list, which I’ve summarized for you here:

  1. Is the company growing dividends faster than inflation (roughly 3%), over the last three years? I personally look for dividend growth that’s at least twice the rate of inflation.
  2. Has the payout ratio risen, stayed the same, or fallen over the last three years? I like investments with a flat or declining payout ratio. If the payout ratio is rising, the dividend growth rate should be discounted appropriately.
  3. Is the three-year average payout ratio less than 60%? High payout ratios can often lead to poor growth or an over-leveraged business. I generally look for payout ratios less than 60%. Any payout ratio higher than 60% would be at risk of being cut if there was any kind of business disruption.
  4. Has the company maintained a debt to equity ratio under 1.5? Companies that are funded with too much debt (instead of equity) have a tendency to cut dividends when the going gets rough. I look for stocks with lower debt levels.
  5. Has the company been able to consistently maintain Net Margins over 7%? High net margins that can be maintained are a good indicator of pricing power. A company that can maintain high net margins usually has some form of moat or niche business with little competition. Pricing power is important for maintaining a strong and growing dividend.
  6. Does the company maintain a ROIC level that exceeds 20%? Since our investment isn’t paying out 100% of profits as a dividend, some of that capital is retained and reinvested. The company should be able to invest that capital in places that have good rates of return.
  7. Is the diluted share count falling or rising? Companies that can buy back shares faster than they issue them build value for investors by “shrinking the pie”. Conversely, companies that issue shares faster than they buy them back should be avoided.

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