Understanding Return on Investment with Dividend Stocks

by Dividend Growth Investor | September 16, 2013 1:00 am

The goal of every dividend investor[1] should be generating a dependable income stream which grows over time. Dividend investors should not sacrifice the relative safety of their principal. While stock prices fluctuate and stocks do not have a guaranteed maturity price like bonds, investors should not lose track of security of principal in their quest for yield.

Investors are automatically sacrificing the income and principal of their investments by chasing yield[2], overpaying for the equities they purchase and failing to properly understand the business and its prospects they buy into.

The Dean of Wallstreet, Ben Graham, came up with the following definition of what an investment should achieve: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

Dividend investors should thoroughly analyze the companies they invest in, to make sure their financial foundation is sound. A sound foundation such as a plan for growth, can result in increase in earnings and dividends over time.

In addition, it is imperative that dividend investors also evaluate valuation[3] of the company whose stock they are purchasing. Even the best dividend paying companies such as Coca-Cola (KO[4]) are not worth purchasing at any price. Investors, who purchased the stock at the highs in 1998, are still sitting at unrealized losses, and the only return they have generated has been from the rising dividend.

Investors should also avoid chasing yield[5] without understanding the reasons behind it. For example, there has been a lot of interest about mortgage REITs such as American Capital Agency (AGNC[6]) and Annaly Mortgage (NLY[7]). Retirees are easily attracted to the mouthwatering yields on these investments. However after observing and discussing investors who own these securities, I have come to the conclusion that many are new to dividend investing in general, they do not understand the risks behind these companies.

It is also evident that many probably have not spent the time to understand how these REITs generate these distributions. These observations are not scientific in their nature of course, and I hope I am wrong on them. The reason why I am unsure about these investments is because their distributions fluctuate greatly, as they are affected by the difference between short term borrowing close to the Fed Funds rates and subsequent investment in mortgage backed securities issued by Fannie Mae or Freddie Mac. Forecasting long-term interest rates is an exercise in futility, and so is the exercise of forecasting the spreads between interest rates on mortgage backed securities and federal funds rates.

For example, if I purchased Annaly shares at the end of 2004, I would have paid $19.62per share and expected to earn 50 cents per share every quarter. This was a very nice 10% yield. The company paid $1.04 per share in 2005, which is a neat 5% yield, but almost half of what was expected to be paid.

In 2006, Annaly distributed 57 cents per share, which represented another 50% decline in distributions, bringing the yield on cost to 3%. Another mREIT, Capstead Mortgage (CMO[8]) decreased distributions from 22 cents per share at the end of 2004 to 2 cents per share for a two year periods between 2005 and 2007. This was down from a high of 53 cents per share earlier in 2004.

One typical reason for investing in a high yielding stock like Annaly Mortgage is the fact that the retiree did not save a sufficient amount of funds during their working years. As a result, these retirees need a super high yielding stock in order to pay for expenses in retirement.

However, by focusing only on the highest yielding stocks[9], these investors are exposing themselves to wide fluctuations in distributions and stock prices. Over time, the value of money decreases due to inflation. If our investor takes a 10% yield, and spends all of it, eventually their standard of living will decline. Add in the uncertainty as to the amount of these distributions, and the situation could become potentially very dire. That being said, mREITs could bring in some level of exposure to a dividend portfolio and might work for some investors who thoroughly understand the risks. they are taking

At the same time, investors who focused on traditional dividend growth stocks saw increases in dividend incomes, albeit they received much smaller initial distributions. However, most dividend growth stocks have stable and growing distributions, which do not fluctuate and make living off dividends[10] much easier.

In comparison Realty Income (O[11]) traded at $25.29 per share at the end of 2004 and paid monthly dividends of 10.90 cents per share, thus yielding 5.20%. The monthly dividend was never cut, and it increased to 11.60 cents per share by 2005 and 12.60 cents per share by 2006. The main difference is that the revenues for Realty Income are coming from recurring rent checks from its hundreds of properties, whereas the distributions from mREITs come from fluctuating spread between short term borrowing and the rates on mortgage backed securities.

Full Disclosure: Long O

  1. of every dividend investor: http://www.dividendgrowthinvestor.com/2009/11/what-are-your-dividend-investing-goals.html
  2. by chasing yield: http://www.dividendgrowthinvestor.com/2009/01/dont-chase-high-yielding-stocks-blindly.html
  3. also evaluate valuation: http://www.dividendgrowthinvestor.com/2010/08/buy-and-hold-dividend-investing-is-not.html
  5. should also avoid chasing yield: http://www.dividendgrowthinvestor.com/2008/02/number-one-reason-why-i-dont-chase-high.html
  6. AGNC: http://studio-5.financialcontent.com/investplace/quote?Symbol=AGNC
  7. NLY: http://studio-5.financialcontent.com/investplace/quote?Symbol=NLY
  8. CMO: http://studio-5.financialcontent.com/investplace/quote?Symbol=CMO
  9. the highest yielding stocks: http://www.dividendgrowthinvestor.com/2013/03/are-these-high-yield-dividends.html
  10. make living off dividends: http://www.dividendgrowthinvestor.com/2010/04/living-off-dividends-in-retirement.html

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