Looking for a better source of investment income? Stock dividends can provide good returns

When they want a steady income, many people buy bonds or put their money in a time deposit.

An attractive alternative is stocks that pay dividends, which can offer higher returns and reliable pay-outs.  

Dividends are payments by companies to distribute part of their income to investors.

While the amount of the dividend can vary over time, since income can go up or down, most companies try to maintain or raise their dividends and show that they are performing well.

Most dividend-paying stocks pay investors a set amount quarterly or twice-yearly, and some companies in Singapore also pay a bonus dividend based on their results.

Top companies increase their payments over time, so investors can build a regular income stream that may grow. 

WHY STOCK DIVIDENDS ARE BENEFICIAL

A key reason for investors who want a regular income to look at stocks that pay higher dividends is that interest rates on alternatives such as time deposits or bonds are relatively low. Interest rates below 2 per cent on time deposits, for example, are somewhat unattractive.

And although DBS bank found that Singapore bonds have provided returns ranging from 2.4 to 5 per cent a year over the past 20 years, a leading bond fund such as the ABF Singapore Bond Index Fund has averaged a return of just 2.16 per cent over the past 3 years.       

Returns on stocks can be relatively better, with higher-paying stocks and real estate investment trusts (Reits) returning 4 to 5 per cent or more.

Research also shows positive results for both investment returns and income.

Financial services firm Merrill Lynch found, for instance, that stocks with a history of increasing their dividends each year produced higher returns with less risk than non-dividend-paying stocks from 1990 through 2018.

Income-minded investors seeking protection from the bumpy road ahead may find dividend-paying stocks warrant a place in their stock portfolios, Merrill Lynch says.

Investment advisory firm Heartland Advisors similarly found that dividend-paying stocks have historically provided higher cumulative returns with less volatility than non-dividend paying stocks over the longer term, including during moderate and even severe market drops. 

THE RISKS TO NOTE

Investors do need to realise, though, that management can reduce or eliminate the dividend if the company is performing poorly or there is an opportunity to use the funds to grow the firm.

Heartland also noted that stocks with higher dividends have underperformed in sharp market recoveries.

Additionally, investment advisory firm Vanguard found that substituting dividend stocks for fixed income such as bonds raises a portfolio’s risk profile and reduces its downside protection.

Dividend-oriented stocks also tend to be more sensitive to interest-rate changes than other stocks, and substituting stocks for bonds may expose investors to unintended consequences such as losing the diversification provided by high-quality bonds.

That said, Vanguard also found that investing in stocks with high dividend yields or those with a history of growing their dividends have produced higher returns with less volatility than the global stock market, and these stocks have also handily outperformed the global bond market.

HOW TO PICK STOCKS FOR INCOME

While dividend-paying stocks can provide good returns, it is important to select the right ones.

One way is to build a portfolio of individual stocks.

Even though it takes time and effort, selecting stocks enables you to receive higher returns than by buying an exchange-traded fund (ETF) or a mutual fund.

Investment adviser Nerdwallet suggests a four-step process.

• Look on brokerage firm or other financial websites for stocks that pay higher dividends.

• Analyse the company’s financial statements to make sure it is a healthy firm that can sustain its dividend.

• Analyse the safety of the dividend by looking at the company’s payout ratio — the percentage of income it pays in dividends — to make sure it is generating enough income to keep paying. The lower the ratio, the safer the dividend and the faster the dividend can grow.

• Buy a diversified set of stocks to optimise your risk, and determine what percentage of your portfolio goes into each stock.

Wyatt Investment Research similarly suggests that knowing a company’s record of dividend increases and calculating dividend growth is important for investors to determine whether to buy or keep a dividend stock.  

As an example of what to look for, investment advisory firm The Motley Fool noted that DBS’ dividend per share rose from S$0.58 in 2014 to S$1.20 in 2018 and it recently reiterated its policy of paying sustainable dividends that increase progressively. 

Airport services operator Sats has also been growing its dividends steadily.

One way to buy dividend stocks, The Motley Fool suggests, may be to buy high-quality dividend stocks in increments on a regular basis.

If you don’t have the time or expertise to select individual stocks that pay higher dividends, another option is to buy an ETF that invests in a diversified portfolio of dividend-paying stocks.

Investment newsletter The Edge says that dividend-focused ETFs in Singapore include the One Stoxx Asean Select Dividend Index Fund, the CIMB S&P Ethical Asia Pacific Dividend ETF, and the Phillip SGX Asia-Pacific Dividend Leaders Reit ETF.

While they do have higher risks than bonds or time deposits, investing in stocks or Reits with higher dividends, or ETFs focused on higher-dividend stocks, can result in relatively good longer-term income.