Dividend Stocks I

So true
Funny how it seems
Always in time
But never in line for dreams
--Spandau Ballet

Last time we discussed two ways that investors can materially benefit from owning stocks: share price appreciation and dividend payouts. Since I have been investing, capital appreciation has been the popular money-making strategy. "How much can the price of that stock go up?" is the primary question to be answered when analyzing potential investments using that mindset.

However, recent circumstances have reminded me of the wealth-building power of portfolios grounded in dividend-paying stocks. Let's review what dividends are. Dividends are cash payments by companies to their shareholders, usually on a quarterly basis. Because they usually come from a company's earnings, dividends amount to a form of profit-sharing.

Consider Johnson & Johnson (JNJ). The health care company was founded in 1886, and has been paying a dividend since 1944. That dividend payout has increased in each of the past 56 years. After announcing this year's increase, JNJ will pay a quarterly dividend of $0.90/share, or $3.60 annually. With JNJ currently trading at about $137 per share, its annual dividend yield is $3.60/$137 = 2.6%.

While it may not seem like much, this 2.6% dividend yield beats the yield of many fixed income instruments. Moreover, JNJ's cash payout is likely to increase in future years. Over the past five years, the dividend has grown about 6.4% annually. If it continues to grow at a 6% annual rate over the next decade, then that $3.60/share payout will turn into $6.44/share. If JNJ's share price stood still during this period, then the new dividend yield becomes $6.44/$137 = 4.7%.

You will be hard-pressed to find other investment ideas in today's world that have that kind of profile for increasing cash-in-hand payouts over time.

Of course, JNJ's share price likely won't stand still over the next decade. It could decline, thereby reflecting an important risk associated with investing in dividend paying stocks: capital loss. A 2.6% decline in JNJ's stock price effectively wipes out a year's worth of dividends.

It should be noted, however, that dividend payouts serve to offset price depreciation to some degree. Here's what I mean. Suppose that you buy JNJ at today's price of $137/share and hold onto it for this year and the next ten after that. If the dividend increases as projected above, then you would collect dividends of almost $54 for each share that you own over the course of the period. For this investment to be a losing proposition 11 years from now, JNJ stock would have to decline $137 - $54 = $83. That's a nice buffer that cushions investors from price declines.

The other major risk associated with dividend-paying stocks is that the company could decrease or eliminate the dividend. Johnson & Johnson's business could turn bad thereby causing profits to decline and the source of dividend payouts to disappear. Because JNJ operates in competitive markets where entrepreneurial innovation regularly renders business models obsolete, it is certainly possible that the company's prospects could decline in the future.

By the same token, however, JNJ has prospered for over a century by being a dominant force in the industries that it serves. If JNJ's competitive position remains strong, then there is a good chance that the share price will go up in the future as the business continues to create value.

This presents a compelling case for owning dividend-paying stocks. Not only can investors benefit from collecting real cash payments that may grow over time, but shareholders can also participate in share price appreciation should the underlying company's business prospects improve in the future.

In part II of this discussion, we'll consider the implications of investing in dividend-paying stocks on portfolios for both young and old.

position in JNJ