Risk is everything when it comes to the stock market. Some financial advisors will promise this & that when it comes to returns, but behind the scenes they are working very hard to manage you investment. This is why they charge so much.
As we all know, growth stocks are riskier investments, whereas dividend stocks are less so. The ideal plan is plan your portfolio, to hedge you dividend payments against any losses you make on growth stocks. Remember, growth stocks are high risk, high reward… Dividend stocks help lower that risk.
Dividend stocks can be used to hedge against losses made when speculating on growth stocks. A great example is using a company like Coca-Cola, a well established dividend aristocrat that pays a generous dividend to investors, then choosing a growth company like Alibaba to speculate with.
Not only will you likely see asset appreciation with Coca-Cola, but you will also receive dividend payments as a bonus of investing. If you unfortunately make a bad decision and your growth stock declines in value, your losses will be offset by the Coca-Cola dividends, hopefully bringing you back to a breakeven point.
You need to know… Dividend stocks are not always safe!
How are We Managing Our Risk?
Growth stocks can be incredibly risky, you are putting faith in the company directors to outperform previous expectations. First and foremost, you aren’t really sure what the company is planning, you can only speculate.
Because of this speculation, a lot of volatility can arise. To combat this volatility you need to balance your portfolio with solid blue chip stocks that offer regular dividends.
It is important to diversify your portfolio with a lot of different means of income, and ways of gaining income from different industries. If you have all your eggs in 1 basket, then you drop it, it is not good.
The Main Problem with Growth Stocks
Growth stocks are generally new to the market, either they have a new technology that revolutionises the way the industry works, or they are creating a new industry by fixing a common problem.
New technologies are difficult to protect, because the bigger companies with large cash balances can make them cheaper and better. Patent protection isn’t always a solution for smaller companies.
Then the problem with emerging into a new industry is… You have others trying to compete with you. And there’s almost no way of telling which company will come out on top.
Even if you pick the company with the most profit, best cash flows, greatest management team, and brightest looking future. There is no guarantee that the stock will increase in value.
Why we Invest in Dividend Stocks
We invest in dividend paying stocks to offset any losses made from growth companies.
I would hope as investors you guys are able to pick more winning companies than losing, but all it takes is a stock to go the opposite way to ruin your portfolio.
For a solid portfolio the general split between dividend stocks & growth stocks should be 80% dividend payers, and 20% growth companies.
That way, if your growth companies reduce in value, or stay stagnant, your dividends can be used to continue building your account.
Example of Dividend Hedging
If you were like me back in 2016 you bought into a company called First Solar Inc (FSLR), a solar panel manufacturer based in Arizona.
The company had been through rough times between 2010 and 2015, but green energy was the focus of the public and more importantly, the government. So I believed solar panels would be in high demand… The stock looked prime to takeoff.
In early 2016 the share price continued to grow, however in 2018, the company sore the share price decrease by 55%. (My investment was only down 34%).
I was lucky that I hedged my investment with the long term dividend payment stock Coca-Cola. In the same time between 2016 and 2018 Coca-Cola’s share price stayed stagnant at around $44 per share. But over that same amount of time I was earning a $0.4 dividend per share each quarter.
Let’s Look at the Math
10 Shares of First Solar @ $56.10 per share = $561.00
50 Shares of Coca-Cola @ $41.50 per share = $2,075.00
Loss on First Solar after 2 years holding = $202.70 (10 Shares @ $35.83)
Dividend earned from Coca-Cola in 2 year period = $140.69
Loss without dividend = $202.70
Loss with dividend = $62.01
The share price for First Solar Inc has since recovered and my holding are above breakeven, however at that time I was worried I would have to sell the shares at a massive loss. I was lucky I hedged using dividend stocks, or the loss might have been even more.
A loss still isn’t good, but it is better to be safe than sorry with money.
What Happens When Risk Goes Wrong?
This example is not from my experiences, nor another sole investor, this is to show even the big wigs on Wall Street sometimes under-estimate their risk.
Valeant Pharmaceuticals (BHC) was trading at round $11 per share back in 2009. The company was a top ten favourite of analysts, and was in high demand from growth-oriented investors.
Because of this high demand, the share price rocketed up to $50 per share before 2011. Then went on to post an all time high of $251.92 in July 2015.
Shortly after July 2015, over the course of 9 months, BHC’s share price went from $250.00… All the way down to $22.00, a 91% decline.
I’m telling you this story because, the large hedge fund Pershing Square Capital Management, run by Bill Ackman, already had a large position in the pharmaceuticals company before 2015. But the fund doubled down and bought more expecting it to continue to grow.
After exiting its huge position in late 2016, Bloomberg calculated that the fund had made a loss of $2.8 Billion on the shares purchased in 2015.
The fund was likely buying more and more as the share price fell in 2016 thinking it would bounce back, but what the fund managers failed to see was, with every purchase, the risk of the investment was increasing more and more.
What I’m trying to get at is, if these guys can make bad decisions and lose money with risky growth stocks, so can you. But you need to know when to throw in the towel, because chasing a loser opens you up to massive risk.
Dividend Stocks vs Growth Stocks
|Dividend Stocks||Growth Stocks|
|Investment Length||Long term income investments||Mid to long term asset appreciation|
|Company Valuation||Usually valued fairly||Often overvalued|
|Growth||Low potential for growth||High potential for growth|
|Market Cap||Mid- Large cap stocks||Small – Large cap stocks|
|Disbursements to Investors||Yes – Quarterly dividend payments||Generally no – Might offer dividends once established in market|
|Examples||Banks, Utilities, Consumer driven companies||Various industries, currently tech, energy, and bio-tech companies|
As you can see from the table, dividend stocks are the safer bet for long term investments, but that doesn’t mean you shouldn’t experiment. More stable industries tend to be dividend paying companies, whereas, emerging industries have potential for massive growth.
Picking growth stocks requires more than a couple of hours research. You need to evaluate the entire company, all of the managers and directors, and try to figure out the value of the company to see if it’s worth buying.
Picking a dividend stock might sound easy, but much like growth stocks you need to make sure the company is set for a long and healthy career.
Pick your Dividend Stocks Carefully
Dividend stocks are just a good way to leverage against loss, they are good long term income investments.
There are a couple of factors that tie the best dividend stocks together, most of which are present on the Dividend Aristocrats List. These factors include:
- Stock Valuation
- Company Size
- Free Cash Flow Levels
- Dividend Payout Ratio
- Industry Size & Leaders
Not often, but some cases, dividend stocks can be overvalued. This can lead to investors being undercut when the market corrects itself. Yes, they will still offer a dividend, but it may be cut as a result of the falling share price.
Most dividend paying companies are large cap stocks with huge excess cashflows. The excess free cash is a good sign for two reasons… It shows the company is looking to reinvest earnings to promote growth. Or they are likely to increase the dividend payment.
Dividend payout ratio is a tricky one. I suggest you read my other article about the perfect payout ratio so you have a better understanding of the subject. Basically, a company with a larger payout ratio, could fall into financial difficulties if profit decreases or cash flow is used up in production. You want to find a company that rewards investors fairly, without putting themselves at risk for the future.
When choosing dividend stocks, the bigger the industry the better. Not only that, but industry leaders such as AT&T, Apple, and JP Morgan Chase have so much market capital and exposure, the likelihood of them cutting dividends is very low.
5 Reasons you Should Become a Dividend Growth Investor
Dividend growth investors have the best of both worlds, they have the potential to seek large gains through growing industries while taking advantage of the dividend paying companies in those industries.
These are 5 simple reasons why you should consider diversifying your portfolio to take advantage of a wider range of stocks.
- Dividends are a source of long term passive income: From 1930 to 2017 dividends accounted for about 42% of the S&P 500 index’s total return. Many new investors in todays market look at Amazon and Google for asset appreciation, but over long periods of time, dividends win.
- Dividend growth stock have outperformed the market over time: It might seem apparent that dividend paying companies struggle to grow, but they do, just at a slower rate. Again, from 1930 to 2017 dividend paying stocks returned 9.25% per year on average, beating the S&P 500 which stands at 7.7% per year. Stocks that don’t offer dividends grew on average 2.6% per year.
- You can retire with dividend growth stocks: A portfolio made up of dividend stocks and growth stocks can ensure your retirement fund. By growing year on year, you can live comfortably on dividends and the capital can be used even after you’re gone.
- Becoming a dividend growth investor can help you avoid common mistakes at times of uncertainty: If the market goes through a bear period, or a specific industry experiences a downfall, many investors will go through a psychological principle called ‘loss aversion’. But you are drawing a reasonable amount of dividend from the stock, you are more likely to hold onto it. Most of the time, dividend stocks will bounce back after market corrections, that’s why we have so many.
- Dividend growth investors aren’t affected by short term volatility: Sudden rises and falls in share price can fool some investors, but the reality is, the value of the company hasn’t changed, only the share price. Getting past your fear in small price movements is key to growing a long term position in a company.
At the end of the day, building wealth in the stock market is easy through dividend growth stock strategies… In theory!
Fear and impatience leads a lot of us to fail at this simple task of leaving money in an account where it will grow. Taking advice from the wrong people, overtrading, and poor research will lead to failure in the dividend growth game.
What are Dividend Growth Stock & Why are They Hard to Find?
A dividend growth stock is a company that offers a small amount of profit as dividend to investors, while keeping the majority of cash flow for future growth.
These companies usually increase their dividend payouts slowly, so if you can get in on the ground floor it’s perfect. It is not only a good sign that the company is covering its expenses and still growing, but they are doing this while rewarding investors.
As you can probably tell, because these companies are so perfect, they are hard to come by… But there are a couple of examples.
- And… Visa
These companies in my opinion are currently overvalued, however some believe they have a lot more growth to do.
The advances in technology made in the last decade has lead to these companies becoming the new era of dividend growth stocks. Offering reasonable dividend payouts while also having over 15% returns year on year.