Thursday, March 24, 2011

Greener Pastures in Rising Dividends

As part of my general investment philosophy, I tend to avoid investing in individual stocks because of my preference for low-cost, highly efficient and diversified index funds. After all, it's been proven that over the long-term, picking stocks is a loser's game and we often resort to market timing - shifting in and out of stocks to capture potential future price movements - which is a costly and ineffective strategy.

However, I do believe in the importance of dividend-paying stocks, particularly those that have a long history of raising dividend payouts and returning excess cash to shareholders. Most of the companies who are able to do this have two things in common: 1). A tremendous amount of brand equity 2). Large amounts of free cash flow

Thus, if a company is borrowing money to meet a quarterly dividend payout, it's likely that financial distress is on the horizon (or is there already). So why do I recommend owning a basket of dividend stocks? In addition to your index fund investments, you can experience the true benefits of compounding if you own 5-10 large dividend payers and simply reinvest their dividends to buy more shares. Ultimately, not only will you receive more and more dividends because you'll have more shares, but if a company has been good about initiating dividend increases consistently, the benefits of compounding become even more apparent because you'll be receiving a higher payout from the company.

Even better, this strategy is important for retirement because your income needs grow larger as you get older. What better way to have a large amount of quarterly income come in than to have all of those years of reinvested dividends now take the form of a quarterly check to you? I tend to stick with large companies who have a history of dividend increases in highly defensive industries. This strategy is much better than simply buying a couple of bonds because there are no maturity dates associated with individual stocks and it's less likely than inflation will eat away at returns because companies that have a history of raising dividends will likely do so at a rate higher than inflation.

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