Stock-Picking Strategies: Income Investing

As the name implies, income investors try to generate a steady income out of their investments. While fixed-income securities such as bonds and CDs have been popular with income investors in the past, the low yields we’ve seen in recent years have made it difficult to generate meaningful returns. Fortunately, there are plenty of dividend-paying stocks that can be used to generate a steady income stream.

Who Pays Dividends?

Not all companies pay a dividend. If a company has earned a profit, it has some options when it comes to using that money. Companies that earn a profit can:

• Reinvest their profits through expansion, debt reduction and/or share repurchases

• Pay a portion of their profits to shareholders through dividends

• Both reinvest and pay out to shareholders

Younger companies in rapidly expanding industries tend not to pay dividends because they want to reinvest as much money as possible into further growth – for example, they might use the money to start a new project, buy new assets, repurchase some of their shares or acquire another company.

Even stable, mature companies might avoid paying dividends if they feel they can do a better job of increasing value and share price by reinvesting earnings. Berkshire Hathaway (BRK-A, BRK-B), for example, does not pay a dividend because Warren Buffett – the company’s chairman and CEO – believes that reinvesting provides more long-term value to shareholders (the company did pay one dividend back in 1967).

Typically, dividends are paid by older, more established companies that have already reached a certain size and are no longer able to sustain higher levels of growth. These firms tend to no longer be in rapidly growing industries and – rather than reinvesting retained earnings to grow – pay out retained earnings as dividends to provide a return to shareholders.

Dividend Yield

Rather than focusing on companies with the highest dividends in terms of dollars, income investors gauge potential investments by their dividend yield. A stock’s dividend yield is the expected yearly dividend divided by the current stock price:

Let’s assume stock ABC is trading at $50 per share and the company offers an annual dividend of $5 per share. The dividend yield would be 10% ($5 dividend ÷ $50 share price = 10% dividend yield). If the stock was trading at a higher price, say $100, the dividend yield would decrease to 5% ($5 dividend ÷ $100 share price = 5% dividend yield). If, on the other hand, the stock was trading at a lower price, such as $25, the dividend yield would increase ($5 dividend ÷ $25 share price = 20% dividend yield). (Try Investopedia’s own Dividend Yield Calculator).

These figures are used to illustrate how share price affects dividend yield: keep in mind, however, that a 20% dividend yield would be highly unusual (and likely part of a very risky investment). In reality, average dividend yields are in the 2% to 5% range, depending on the sector. Income investors look for yields towards the top of that range – or above – provided the high dividend is sustainable and can produce a steady and predictable income stream over the long term. Companies that have paid steady dividends over the past five, 10, 15 or 20 years – or longer – are likely to continue that trend.

An Example

There are many good companies that pay great dividends and also grow at a respectable rate. One excellent example of this was Johnson & Johnson from 1963 to 2004. In those years, Johnson & Johnson increased its dividend every year. In fact, if you had bought the stock in 1963 the dividend yield on your initial shares would have grown approximately 12% annually. Thirty years later, your earnings from dividends alone would have rendered a 48% annual return on your initial shares!

Here is a chart of Johnson & Johnson's share price (adjusted for splits and dividend payments), which demonstrates the power of the combination of dividend yield and company appreciation:

This chart should address the concerns of those who simply dismiss income investing as an extremely defensive and conservative investment style. When an initial investment appreciates over 225 times - including dividends - in about 20 years, that may be about as "sexy" as it gets.

Finding good income investing stocks – ones that pay a good dividend and that are expected to continue doing so – takes significant research. You can start by using a stock screener to find companies paying the highest dividend yields, and then analyze them using fundamental analysis – and your own interpretation of the numbers.

Dividends Are Not Everything

You should never invest solely on the basis of dividends. Keep in mind that high dividends don't automatically indicate a good company. Because they are paid out of a company's net income, higher dividends will result in a lower retained earnings. Problems arise when the income that would have been better re-invested into the company goes to high dividends instead.

The income investing strategy is about more than using a stock screener to find the companies with the highest dividend yield. Because these yields are only worth something if they are sustainable, income investors must be sure to analyze their companies carefully, buying only ones that have good fundamentals. Like all other strategies discussed in this tutorial, the income investing strategy has no set formula for finding a good company. To determine the sustainability of dividends by means of fundamental analysis, each individual investor must use his or her own interpretive skills and personal judgment – for this reason, we won't get into what defines a "good company".

Stock Picking, not Fixed Income

Something to remember is that dividends do not equal lower risk. The risk associated with any equity security still applies to those with high dividend yields, although the risk can be minimized by picking solid companies.

Taxes Taxes Taxes

One final important note: in most countries and states/provinces, dividend payments are taxed at the same rate as your wages. As such, these payments tend to be taxed higher than capital gains, which is a factor that reduces your overall return.