Chapter 3
IN THIS CHAPTER
Familiarizing yourself with income stock fundamentals
Selecting income stocks with a few criteria in mind
Checking out utilities, REITs, and royalty trusts
Investing for income means investing in stocks that provide you with regular cash payments (dividends). Income stocks may not be known to offer stellar growth potential, but they’re good for a steady infusion of cash. If you have a low tolerance for risk or if your investment goal is anything less than long-term, income stocks are a better bet than growth stocks. Long-term, conservative investors who need income in their situations can also benefit from income stocks because they have a good track record of keeping pace with inflation (versus fixed-income investments, such as bonds).
The bottom line is that we like dividend-paying stocks, and they deserve a spot in a variety of portfolios. In this chapter, we explain the basics of income stocks, show you how to analyze income stocks with a few handy formulas, and describe several typical income stocks.
We certainly think that dividend-paying stocks are a great consideration for those investors seeking greater income in their portfolios. We especially like stocks with higher-than-average dividends that are known as income stocks. Income stocks take on a dual role in that they can not only appreciate but also provide regular income. The following sections take a closer look at dividends and income stocks.
When people talk about gaining income from stocks, they’re usually talking about dividends. A dividend is nothing more than money paid out to the owner of stock. You purchase dividend stocks primarily for income — not for spectacular growth potential.
Dividends are sometimes confused with interest. However, dividends are payouts to owners, whereas interest is a payment to a creditor. A stock investor is considered a part owner of the company he invests in and is entitled to dividends when they’re issued. A bank, on the other hand, considers you a creditor when you open an account. The bank borrows your money and pays you interest on it.
A dividend is quoted as an annual number but is usually paid on a quarterly basis. For example, if a stock pays a dividend of $4, you’re probably paid $1 every quarter. If, in this example, you have 200 shares, you’re paid $800 every year (if the dividend doesn’t change during that period), or $200 per quarter. Getting that regular dividend check every three months (for as long as you hold the stock) can be a nice perk. A good income stock has a higher-than-average dividend (typically 4 percent or higher).
What type of person is best suited to income stocks? Income stocks can be appropriate for many investors, but they’re especially well-suited for the following individuals:
Income stocks tend to be among the least volatile of all stocks, and many investors view them as defensive stocks. Defensive stocks are stocks of companies that sell goods and services that are generally needed no matter what shape the economy is in. (Don’t confuse defensive stocks with defense stocks, which specialize in goods and equipment for the military.) Food, beverage, and utility companies are great examples of defensive stocks. Even when the economy is experiencing tough times, people still need to eat, drink, and turn on the lights. Companies that offer relatively high dividends also tend to be large firms in established, stable industries.
Before you say, “Income stocks are great! I’ll get my checkbook and buy a batch right now,” take a look at the following potential disadvantages (ugh!). Income stocks do come with some fine print.
Income stocks can go down as well as up, just as any stock can. The factors that affect stocks in general — politics, megatrends, different kinds of risk, and so on — affect income stocks, too. Fortunately, income stocks don’t get hit as hard as other stocks when the market is declining because high dividends tend to act as a support to the stock price. Therefore, income stocks’ prices usually fall less dramatically than other stocks’ prices in a declining market.
Income stocks can be sensitive to rising interest rates. When interest rates go up, other investments (such as corporate bonds, U.S. Treasury securities, and bank certificates of deposit) are more attractive. When your income stock yields 4 percent and interest rates go up to 5 percent, 6 percent, or higher, you may think, “Hmm. Why settle for a 4 percent yield when I can get 5 percent or better elsewhere?” As more and more investors sell their low-yield stocks, the prices for those stocks fall.
Another point to note is that rising interest rates may hurt the company’s financial strength. If the company has to pay more interest, that may affect the company’s earnings, which in turn may affect the company’s ability to continue paying dividends.
Although many companies raise their dividends on a regular basis, some don’t. Or if they do raise their dividends, the increases may be small. If income is your primary consideration, you want to be aware of this fact. If you’re getting the same dividend year after year and this income is important to you, rising inflation becomes a problem.
Say that you have XYZ stock at $10 per share with an annual dividend of 30 cents (the yield is 30 cents divided by $10, or 3 percent). If you have a yield of 3 percent two years in a row, how do you feel when inflation rises 6 percent one year and 7 percent the next year? Because inflation means your costs are rising, inflation shrinks the value of the dividend income you receive.
Fortunately, studies show that in general, dividends do better in inflationary environments than bonds and other fixed-rate investments. Usually, the dividends of companies that provide consumer staples (food, energy, and so on) meet or exceed the rate of inflation.
The government usually taxes dividends as ordinary income. Find out from your tax person whether potentially higher tax rates on dividends are in effect for the current or subsequent tax year. See Book 2, Chapter 3 for more information on taxes for investors.
As we explain in the preceding section, even conservative income investors can be confronted with different types of risk. (Book 1, Chapter 2 covers risk and volatility in greater detail.) Fortunately, this section helps you carefully choose income stocks so you can minimize potential disadvantages.
You choose income stocks primarily because you want or need income now. As a secondary point, income stocks have the potential for steady, long-term appreciation. So if you’re investing for retirement needs that won’t occur for another 20 years, maybe income stocks aren’t suitable for you — a better choice may be to invest in growth stocks because they’re more likely to grow your money faster over a lengthier investment term. (We explain who’s best suited to income stocks earlier in this chapter.)
If you’re certain you want income stocks, do a rough calculation to figure out how big a portion of your portfolio you want income stocks to occupy. Suppose that you need $25,000 in investment income to satisfy your current financial needs. If you have bonds that give you $20,000 in interest income and you want the rest to come from dividends from income stocks, you need to choose stocks that pay you $5,000 in annual dividends. If you have $100,000 left to invest, you need a portfolio of income stocks that yields 5 percent ($5,000 divided by $100,000 equals a yield of 5 percent; we explain yield in more detail in the following section).
You may ask, “Why not just buy $100,000 of bonds (for instance) that may yield at least 5 percent?” Well, if you’re satisfied with that $5,000, and inflation for the foreseeable future is 0 or considerably less than 5 percent, then you have a point. Unfortunately, inflation (low or otherwise) will probably be with us for a long time. Fortunately, the steady growth (of their dividends) that income stocks provide is a benefit to you.
Because income stocks pay out dividends — income — you need to assess which stocks can give you the highest income. How do you do that? The main thing to look for is yield, which is the percentage rate of return paid on a stock in the form of dividends. Looking at a stock’s dividend yield is the quickest way to find out how much money you’ll earn versus other dividend-paying stocks (or even other investments, such as a bank account). Table 3-1 illustrates this point. Dividend yield is calculated in the following way:
Dividend yield equals Dividend income divided by Stock investment
TABLE 3-1 Comparing Yields
Investment |
Type |
Investment Amount |
Annual Investment Income (Dividend) |
Yield (Annual Investment Income Divided by Investment Amount) |
Smith Co. |
Common stock |
$20 per share |
$1.00 per share |
5% |
Jones Co. |
Common stock |
$30 per share |
$1.50 per share |
5% |
Wilson Bank |
Savings account |
$1,000 deposit |
$10.00 (interest) |
1% |
The next two sections use the information in Table 3-1 to compare the yields from different investments and to show how evaluating yield helps you choose the stock that earns you the most money.
Most people have no problem understanding yield when it comes to bank accounts. If we tell you that a bank certificate of deposit (CD) has an annual yield of 3.5 percent, you can easily figure out that if you deposit $1,000 in that account, a year later you’ll have $1,035 (slightly more if you include compounding). The CD’s market value in this example is the same as the deposit amount — $1,000. That makes it easy to calculate.
All things being equal, choosing Smith Co. or Jones Co. is a coin toss. It’s looking at your situation and each company’s fundamentals and prospects that will sway you. What if Smith Co. is an auto stock (similar to General Motors in 2008) and Jones Co. is a utility serving the Las Vegas metro area? Now what? In 2008, the automotive industry struggled tremendously, but utilities were generally in much better shape. In that scenario, Smith Co.’s dividend is in jeopardy, whereas Jones Co.’s dividend is more secure. Another issue is the payout ratio (see the next section). Therefore, companies whose dividends have the same yield may still have different risks.
You can use the payout ratio to figure out what percentage of a company’s earnings is being paid out in the form of dividends (earnings = sales – expenses). Keep in mind that companies pay dividends from their net earnings. Therefore, the company’s earnings should always be higher than the dividends the company pays out. Here’s how to figure a payout ratio:
Dividend (per share) divided by Earnings (per share) equals Payout ratio
Say that the company CashFlow Now, Inc. (CFN), has annual earnings (or net income) of $1 million. Total dividends are to be paid out of $500,000, and the company has 1 million outstanding shares. Using those numbers, you know that CFN’s earnings per share (EPS) is $1 ($1 million in earnings divided by 1 million shares) and that it pays an annual dividend of 50 cents per share ($500,000 divided by 1 million shares). The dividend payout ratio is 50 percent (the 50 cent dividend is 50 percent of the $1 EPS). This number is a healthy dividend payout ratio because even if CFN’s earnings fall by 10 percent or 20 percent, plenty of room still exists to pay dividends.
Bond rating? Huh? What’s that got to do with dividend-paying stocks? Actually, a company’s bond rating is very important to income stock investors. The bond rating offers insight into the company’s financial strength. Bonds get rated for quality for the same reasons that consumer agencies rate products like cars or toasters. Standard & Poor’s (S&P) is the major independent rating agency that looks into bond issuers. S&P looks at the bond issuer and asks, “Does this bond issuer have the financial strength to pay back the bond and the interest as stipulated in the bond indenture?”
To understand why this rating is important, consider the following:
If a bond rating agency lowers the rating, that means the company’s financial strength is deteriorating — a red flag for anyone who owns the company’s bonds or stock. A lower bond rating today may mean trouble for the dividend later on.
If most of your dividend income is from stock in a single company or single industry, consider reallocating your investment to avoid having all your eggs in one basket. Concerns about diversification apply to income stocks as well as growth stocks. If all your income stocks are in the electric utility industry, then any problems in that industry are potential problems for your portfolio as well. See Book 1, Chapter 2 for more on risk.
Although virtually every industry has stocks that pay dividends, some industries have more dividend-paying stocks than others. You won’t find too many dividend-paying income stocks in the computer or biotech industries, for instance. The reason is that these types of companies need a lot of money to finance expensive research and development (R&D) projects to create new products. Without R&D, the company can’t create new products to fuel sales, growth, and future earnings. Computer, biotech, and other innovative industries are better for growth investors. Keep reading for the scoop on stocks that work well for income investors.
Utilities generate a large cash flow. (If you don’t believe us, look at your gas and electric bills!) Cash flow includes money from income (sales of products and/or services) and other items (such as the selling of assets, for example). This cash flow is needed to cover expenses, loan payments, and dividends. Utilities are considered the most common type of income stocks, and many investors have at least one utility company in their portfolio. Investing in your own local utility isn’t a bad idea — at least it makes paying the utility bill less painful.
www.census.gov
).Real estate investment trusts (REITs) are a special breed of stock. A REIT is an investment that has elements of both a stock and a mutual fund (a pool of money received from investors that’s managed by an investment company).
The main advantages to investing in REITs include the following:
Many of the dangers of the “housing bubble” have passed, and investors can start looking at real estate investments (such as REITs) with less anxiety. However, choosing REITs with a view toward quality and strong fundamentals (location, potential rents, and so forth) is still a good idea.
In recent years, the oil and gas sector has generated much interest as people and businesses experience much higher energy prices. Because of a variety of bullish factors, such as increased international demand from China and other emerging industrialized nations, oil and gas prices have zoomed to record highs. Some income investors have capitalized on this price increase by investing in energy stocks called royalty trusts.
Royalty trusts are companies that hold assets such as oil-rich and/or natural gas–rich land and generate high fees from companies that seek access to these properties for exploration. The fees paid to the royalty trusts are then disbursed as high dividends to their shareholders. During 2015, royalty trusts sported yields in the 6 to 10 percent range, which is very enticing given how low the yields have been in this decade for other investments like bank accounts and bonds.