Below are four basic principles to dividend investing, I’ve underlined a key word in two. Principles #2 and #4 are far and away the most important, why? Because these are the two that an active dividend investor can exercise the most control over, and they offer the smart dividend investor the ability to increase capital gains when dividends are increasing while avoiding capital losses when dividends are decreasing. What matters more than a dividend increase or reduction is the capital gain you can capture or loss you avoid up to 1-year before the announcement is made.
- Dividend cuts are bad when they happen
- Dividend cuts are bad before they happen
- Dividend increases are good when they happen
- Dividend increases are good before they happen
In this piece we are going to show proof for each of the tenets and offer some basic principles to help smart dividend investors make smart dividend decisions. This article will lean heavily on a Fidelity white paper published in 2012.
- Dividend cuts are bad when they happen: But research has shown that a well anticipated dividend cut does not have the same negative impact as an unexpected dividend cut. In other words, it’s the surprise that is bad. There are even cases of stock prices rising immediately following a dividend cut. There are typically two reasons for this; (1) the company has found a more productive use of cash and has proven this to investors who are now willing to value the stock higher given a higher return by from reinvestment; and (2) the dividend cut was already fully priced into the stock, and the effect of not cutting would result in decreased financial capacity, so the dividend results in a preservation of capital which is seen as a positive thing by investors. Despite these two situations, by and large dividend cuts bring lower stock prices and smart dividend investors should avoid stocks likely to cut their divvy’s, one way to avoid painful dividend cuts is by signing up for the SmartDividendStocks.com email.
- Dividend cuts are bad before they happen: The market anticipates a dividend cut before it is announced, which means if you wait until it happens you will not only lose on the downward price action immediately after the cut, but also the year before the cut. Based on Fidelity’s analysis, the average security that cut or suspended its dividend underperformed the market by more than 23% during the 12 months preceding the official announcement of the dividend cut or suspension. The smart dividend investor must avoid, and the further an exit is made ahead of a cut the better off we are, which is why we pay close attention to our Dividend Safety Score when assessing dividend investments.
- Dividend increases are good when they happen: Similar to the first tenet, the element that matters most is surprise. A dividend aristocrat that has been raising its annual dividend every year for at least 20 consecutive years will not see the same positive reaction when it announces its 21st dividend increase as it did when it initiated its first. The actual dividend increase is already priced in, that’s not to say it’s a bad thing, in fact it’s great, we at Smart Dividend Stocks love an increasing dividend.
- Dividend increases are good before they happen: To prove this concept, Fidelity built a mock portfolio that looked ahead to which stocks increased their dividends. They discovered that over the past two decades this portfolio that displayed a positive dividend growth characteristic delivered 5.5% of additional active returns (over and above a non-active strategy) and the portfolio had a massive success rate of 82%. In other words, correctly forecasting the next year’s positive dividend growers generates significant excess returns outside of the dividends themselves; these are capital gains that are captured.
Just as the smart dividend investing approach uses research to predict deteriorating fundamentals ahead of dividend cuts or suspensions, the same approach can uncover the best stocks that show improving fundamentals for dividend growth.
Last thoughts: Avoiding risky dividend stocks can be more important than picking good dividend stocks. It’s important to pay attention to a stocks Dividend Safety Score which can help to evaluate the chance of a dividend cut well before it happens, often issuing warning signs many years in advance. Picking stocks that have increasing dividends and good dividend security is a tried and true method of outperforming benchmarks, a good place to start is with the [50 stocks on the Dividend Aristocrats list]. Avoiding dividend cuts in the first place, and predicting dividend increases is what SmartDividendStocks.com is all about, keep in touch with our regular news alert emails.