Explained: Why investing in dividend paying stocks is a good strategy

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Published: February 28, 2018 3:13:56 AM

Let us understand, whether investing in dividend paying stocks is a good strategy for long-term equity investors.

dividend, stocks, shares, dividend paying stocks growth, dividend paying stocksA company is considered successful if it earns profits consistently every year.

A company is considered successful if it earns profits consistently every year. With the profit, the company has three options. It can use the profit to fuel its own growth; it can return some of the profit to the shareholders in the form of dividends; it can buy back its own shares so that each remaining share in market is owned more by the company. Let us understand, whether investing in dividend paying stocks is a good strategy for long-term equity investors.

Dividend paying shares and age of the investors

Many investors, especially retail investors, think that dividend paying shares are generally preferred by retired people or people who have less risk appetite or those looking for regular cash-flow. That is not true. In fact, dividend paying stocks are ideal for younger investors’ because dividends could possibly help to offset the potential decline in stock prices. Further, it is empirically proven that shares with a track record of increasing their dividend, often deliver higher returns with relatively less risk than that non-dividend paying firms. At the same time it is also seen that dividend paying shares are a good option for older or retired investors for a different reason. In the fixed income securities segment, attractive yield is being relatively scarce, investors who want a regular income are turning towards dividend paying shares.

Dividend paying stocks and growth

Again, many investors believe that dividend paying companies lack growth, which is not true. In fact, companies that have a track record of consistently growing dividends offer the strongest total returns to investors. This is because of the simple reason that companies that are committed to pay dividend to investors tend to make smarter decisions and are more prudent in allocation of their capital for reaping higher productivity and profit. This helps to enhance shareholders’ wealth in the long-term.

Prefer to invest in companies with low pay-out ratio

It is a good strategy to identify and invest companies with a lower pay-out ratio. Prefer to invest in those companies who pay out a lower proportion of their earnings as a dividend say, 30% of earnings rather than 80%. Why so? In changing external and market environments when earnings shrink, companies with a lower pay-out ratio may have the latitude to maintain their dividends, whereas companies that pay out a large percentage of their earnings tend to cut their dividends.

Diversify within dividend paying stocks

For investors, sector diversification is essential to enhance long-term returns and mitigate risks to a greater extent. So, within dividend paying stocks, always look at multiple sectors that offer attractive income growth prospects. Especially look at sectors such as large-cap technology and industrial stocks for their potential to grow and for their low pay-out ratios relative to their earnings.
As investors, we all love to have shares that offer some tangible return even if
the share prices swing up and down. Therefore, investing in dividend paying stocks can be a good strategy if you prefer to have regular income. But remember, dividends are not guaranteed, you still have to do your research before selecting the stock to invest.

The writer is Professor, School of Commerce and Management, Central
University of Tamilnadu, Thiruvarur

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