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Why I Like Dividend Paying Companies

Posted on December 15 by

(Helping young entrepreneurs invest for long term capital growth)

If you are a young private investor looking to achieve a consistent reasonable return on your investment in stocks, selecting exclusively companies that pay a dividend may be a good recipe you would like to consider. I will share with you my experience and hope you find it helpful and practical. As always, I will give you my recipe, you put your ingredients.

What is a reasonable return may vary of course from one person to another but in a general economy that is growing by 2 to 3% annually and an inflation rate under 3% per year, a reasonable return would be in the range of 6 to 9%. The 6 to 9% range corresponds to X2 or X3 the inflation rate, i.e. you are covering for the currency depreciation and then some, to preserve the purchasing power of your capital.

A steady appreciation of +/- 8% annually would make you double your capital in 9 to 10 years, which by my standards would be a most decent performance. The key here is to be steady in a market that fluctuates. The steadiness will be greatly influenced by the quality of the companies you select, so chose wisely quality corporations with a good reputation and a steady upward track record.

Another important point to consider is how much money is paid for a stock. Smart investors are cautious of the price they pay to acquire a stock even if the company is a star performer. They do not want to over pay. Growth of dividend is one thing, but paying too much put my capital at risk of a correction. Aim at acquiring quality companies at a reasonable price. What is a reasonable price? With some research you can nail down a price range that appears to be OK. The best tactic here is to keep a watch over a list of target companies and then take advantage of normal price fluctuation.

But, let's get back to our original subject. Why do I pick exclusively companies that pay a dividend? Here are my 4 key reasons:

(1) An alert board: Dividend paying companies have in general more watchful and vigilant boards. Paying of a dividend is like a policy that has been debated and implemented over a number of years, so there is subliminal pressure on the board to continue the tradition. No board worth its salt want to be the one who reduces or cancels the dividend, hence the extra watch on the CEO and the senior team. Are they doing a good job?

(2) Dividend coverage: A good rule of thumb is also expressed by how much the dividend is covered by the net profit of the company. Consider the following example: Company A earns $100 and pays $50 in dividend while company B earns $150 and pay $150 in dividend. While company B pays a higher dividend, most Analysts would select company A because its dividend appears more secure by earnings vs. company B which if facing even a small decline in its earnings would have a problem covering the dividend payment. A coverage around the 50% mark is reasonable for me, i.e. returning 50% of the profits in cash to the shareholders through a dividend and re-investing the remaining 50% of the profits back into the corporation.

(3) Better balance between the short, medium and long term: Companies that pay a dividend tend to also have a more disciplined approach to short, medium and long term planning. Because the board does not only want to continue the tradition of paying a dividend but to also raise the dividend payment consistently. This too puts more accountability on the board to increase the dividend in a manner consistent with history.

(4) Cash flow: Dividend payment provides you with an in-flow of cash on a monthly or quarterly basis which provides an additional option of taking money out without the need to sell shares. While this can be argued to be a relatively nominal benefit, I like it because it makes me separate clearly the capital gain portion of my return from the dividend payment portion.

Companies can return cash to shareholders in three ways; by paying a dividend or by buying their own stock or a combination. Paying a dividend is for me a more disciplined approach because it depends on making a policy and adhering to it vs. buying their own stock depends on external factors, usually when the stock price is depressed.

Selecting companies that pay a dividend is not risk free as history has shown that even well managed companies with a solid record of paying a dividend can go through challenging times that force their boards to either cut or reduce their dividend. Investors should always stay alert and evaluate the business performance of the companies in their portfolio to identify and quantify the risk of investment and the margin of safety.

While there are many rules and tools, analyzing companies performance and future prospects is complex and is more subjective than objective, however, I have found that investing in dividend paying companies provides a more balanced return and better ROI for the long term.

Hugh Latif, of Hugh Latif & Associates in Vaughan, Ontario is a management consultant who helps mid-size, private companies with strategy, succession, advisory boards and HR. He is author of a new book, Maverick Leadership; available from hughlatif.com and amazon.com/ca and Kindle.

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