Stock-Picking Strategies: Income Investing
  1. Stock-Picking Strategies: Introduction
  2. Stock-Picking Strategies: Fundamental Analysis
  3. Stock-Picking Strategies: Qualitative Analysis
  4. Stock-Picking Strategies: Value Investing
  5. Stock-Picking Strategies: Growth Investing
  6. Stock-Picking Strategies: GARP Investing
  7. Stock-Picking Strategies: Income Investing
  8. Stock-Picking Strategies: CAN SLIM
  9. Stock-Picking Strategies: Dogs of the Dow
  10. Stock-Picking Strategies: Technical Analysis
  11. Stock-Picking Strategies: Conclusion

Stock-Picking Strategies: Income Investing


Income investing, which aims to pick companies that provide a steady stream of income, is perhaps one of the most straightforward stock-picking strategies. When investors think of steady income they commonly think of fixed-income securities such as bonds. However, stocks can also provide a steady income by paying a solid dividend. Here we look at the strategy that focuses on finding these kinds of stocks. (For more on fixed-income securities, see our tutorials Bond & Debt Basics and Advanced Bond Concepts.)

Who Pays Dividends?
Income investors usually end up focusing on older, more established firms, which have reached a certain size and are no longer able to sustain higher levels of growth. These companies generally no longer are in rapidly expanding industries and so instead of reinvesting retained earnings into themselves (as many high-flying growth companies do), mature firms tend to pay out retained earnings as dividends as a way to provide a return to their shareholders.

Thus, dividends are more prominent in certain industries. Utility companies, for example, have historically paid a fairly decent dividend, and this trend should continue in the future. (For more on the resurgence of dividends following the tech boom, see How Dividends Work For Investors.)

Dividend Yield
Income investing is not simply about investing in companies with the highest dividends (in dollar figures). The more important gauge is the dividend yield, calculated by dividing the annual dividend per share by share price. This measures the actual return that a dividend gives the owner of the stock. For example, a company with a share price of $100 and a dividend of $6 per share has a 6% dividend yield, or 6% return from dividends. The average dividend yield for companies in the S&P 500 is 2-3%.

But income investors demand a much higher yield than 2-3%. Most are looking for a minimum 5-6% yield, which on a $1-million investment would produce an income (before taxes) of $50,000-$60,000. The driving principle behind this strategy is probably becoming pretty clear: find good companies with sustainable high dividend yields to receive a steady and predictable stream of money over the long term.

Another factor to consider with the dividend yield is a company's past dividend policy. Income investors must determine whether a prospective company can continue with its dividends. If a company has recently increased its dividend, be sure to analyze that decision. A large increase, say from 1.5% to 6%, over a short period such as a year or two, may turn out to be over-optimistic and unsustainable into the future. The longer the company has been paying a good dividend, the more likely it will continue to do so in the future. Companies that have had steady dividends over the past five, 10, 15, or even 50 years are likely to continue the trend.

An Example
There are many good companies that pay great dividends and also grow at a respectable rate. Perhaps the best example of this is Johnson & Johnson. From 1963 to 2004, Johnson & Johnson has increased its dividend every year. In fact, if you bought the stock in 1963 the dividend yield on your initial shares would have grown approximately 12% annually. Thirty years later, your earnings from dividends alone would have rendered a 48% annual return on your initial shares!

Here is a chart of Johnson & Johnson's share price (adjusted for splits and dividend payments), which demonstrates the power of the combination of dividend yield and company appreciation:



This chart should address the concerns of those who simply dismiss income investing as an extremely defensive and conservative investment style. When an initial investment appreciates over 225 times - including dividends - in about 20 years, that may be about as "sexy" as it gets.



Dividends Are Not Everything
You should never invest solely on the basis of dividends. Keep in mind that high dividends don't automatically indicate a good company. Because they are paid out of a company's net income, higher dividends will result in a lower retained earnings. Problems arise when the income that would have been better re-invested into the company goes to high dividends instead.

The income investing strategy is about more than using a stock screener to find the companies with the highest dividend yield. Because these yields are only worth something if they are sustainable, income investors must be sure to analyze their companies carefully, buying only ones that have good fundamentals. Like all other strategies discussed in this tutorial, the income investing strategy has no set formula for finding a good company. To determine the sustainability of dividends by means of fundamental analysis, each individual investor must use his or her own interpretive skills and personal judgment - for this reason, we won't get into what defines a "good company".

Stock Picking, not Fixed Income
Something to remember is that dividends do not equal lower risk. The risk associated with any equity security still applies to those with high dividend yields, although the risk can be minimized by picking solid companies.

Taxes Taxes Taxes
One final important note: in most countries and states/provinces, dividend payments are taxed at the same rate as your wages. As such, these payments tend to be taxed higher than capital gains, which is a factor that reduces your overall return.

Stock-Picking Strategies: CAN SLIM

  1. Stock-Picking Strategies: Introduction
  2. Stock-Picking Strategies: Fundamental Analysis
  3. Stock-Picking Strategies: Qualitative Analysis
  4. Stock-Picking Strategies: Value Investing
  5. Stock-Picking Strategies: Growth Investing
  6. Stock-Picking Strategies: GARP Investing
  7. Stock-Picking Strategies: Income Investing
  8. Stock-Picking Strategies: CAN SLIM
  9. Stock-Picking Strategies: Dogs of the Dow
  10. Stock-Picking Strategies: Technical Analysis
  11. Stock-Picking Strategies: Conclusion
RELATED TERMS
  1. Forward Dividend Yield

    An estimation of a year's dividend expressed as a percentage ...
  2. Dividend

    A distribution of a portion of a company's earnings, decided ...
  3. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends ...
  4. Indicated Yield

    The dividend yield that a share of stock would return based on ...
  5. Accelerated Dividend

    Special dividends paid by a company ahead of an imminent change ...
  6. Sucker Yield

    When an investor has essentially risked all of his capital for ...
RELATED FAQS
  1. What is the difference between yield and dividend?

    Learn how to differentiate between dividend yield and dividend return, and see why dividend yield is the more popular rate ... Read Answer >>
  2. Can dividends be paid out monthly?

    Find out if stocks can pay dividends monthly, and learn about the types of companies most likely to do so and how monthly ... Read Answer >>
  3. What metrics should I evaluate when looking for high-yielding dividend stocks?

    Evaluate high-yield dividend stocks to determine if they are a good investment to produce steady income. Learn what questions ... Read Answer >>
  4. What types of companies offer the most dividends?

    Find out which types of companies tend to offer the most dividends, and learn why dividends must be considered carefully ... Read Answer >>
  5. What can cause the marginal propensity to consume to change over time?

    Learn about the dividend payout ratio and dividend yield, what the ratios measure and the difference between the dividend ... Read Answer >>
  6. What is the difference between the dividend yield and the dividend payout ratio?

    Learn the differences between a stock's dividend yield and its dividend payout ratio, and learn why the latter might be a ... Read Answer >>

You May Also Like

Hot Definitions
  1. Goodwill

    An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company ...
  2. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  3. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  4. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  5. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  6. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
Trading Center