Generate Retirement Income with Dividend Stocks

12th July 2014

Most of people tend to spend their wholes lives accumulating a sufficient amount through saving and investing that they plan to use upon retirement. From the investment point of view, the most challenging part is to ensure that these monies generate a sufficient stream of income when necessary. In theory this should be fairly straightforward, but actually it might be trickier due to the multitude of options, different types of investment products and types of policies.

General minimum requirement that income seeking investors would have is that assets where they invest their monies are able to generate income and also preserve value over time. Dividend paying stocks seem to be a typical example of such asset. These stocks are equity of companies which regularly distribute payments to their shareholders, most often in a form of cash or additional stocks.

In addition to supplying portfolio with a stream of income, dividend paying stocks have other benefits as well. Over the long term, dividends can add substantially to the total returns of stocks. Dividend payers have also historically generated a higher return with lower volatility. Moreover, many research papers provide solid evidence that dividend stocks have not only outperformed the market in good times but they can also provide downside protection during bad times. For instance, comparing the returns of U.S. stocks in 15 bull and 14 bear markets, a Ned Davis research study found that since 1972 S&P dividend payers had outperformed non-payers by 12.5% on an average basis in each bear market while outperforming by 3.4% in each bull market.

Especially in the recent few years dividend stocks are a hot topic among investors. They are a good defensive pick due to stability they lend to a portfolio, which is needed now more than ever in a world of increasing volatility and global macroeconomic concerns. High sovereign debt levels and increasing austerity measures are expected to keep low growth rates. This together with extremely low interest rates (bond yields and short-term interest rates around 0%) makes dividend paying stocks more attractive to investors. Furthermore, demographic factors might be as important as economic ones: a large number of people are moving into retirement and are looking for income from their portfolio. Also as life expectancy has risen retirees need long term capital preservation as well as income. Finally, it is always good to remember that companies that pay dividends typically have better business models, stronger balance sheets and higher growth capabilities. Moreover, dividends are hard to fake or manipulate over long time periods, and thus provide a relatively reliable indicator of company performance and valuation.

There are thousands of dividend paying stocks and thus the search for quality ones is not an easy task. Still one can narrow the list of stocks by applying a few useful criteria:

  • Firstly, a company should have continuously increased distributions for at least ten years in a row. This is widely accepted among analysts and investors as it eliminates all companies which are inconsistent in their dividend policies.
  • The second criterion includes removing all stocks whose dividend payout ratio is higher than 60% - most investors look for a company that has a dividend ratio of between 40% and 60%. A lower payout is generally seen as positive since it leaves space for consistent dividend growth minimising the impact of short-term fluctuations in earnings. Shareholders earn a profit while still allowing the company to roll over the money to increase internal growth. Otherwise a high payout could mean that these companies are investing less money for growth, and consequently cannot afford to pay the distribution so the risk of a dividend cut is high.
  • The third criterion includes removing companies which trade at a price/earnings (P/E) ratio of over 20. This simply means that even the best dividend paying companies are not worth buying at any price. Very often the only returns from such stocks are solely dividend payments, whereas investors would seek at least some capital gain.
  • Finally there should be some rule in terms of dividend yield; typically minimum yields required by investors should be around 2.50%.

Of course these are very general criteria and should always be carefully interpreted and observed on case-to-case basis. It is especially important that multiples i.e. P/E ratio, Earnings per Share ratio (EPS), etc. of the selected company are compared with the industry/ sector benchmark.

How to Invest into Dividend Paying Stocks?

If you would like to access dividend paying stocks, we would typically advise to enter investment funds which are focused on acquiring such equities. We work with a number of well established asset management houses that provide best performing funds in this sector. In case of interest, please do get in touch.