Not Your Parent's Ma Bell

There are some widespread misconceptions and myths about dividend investing and dividend-paying stocks. One of my favorites is that dividend-paying stocks are the slow, boring way to invest. There was a time when being a “dividend investor” was practically synonymous with being a shareholder in public utilities—companies like Ma Bell and Standard Oil. But not anymore.

Stocks like Microsoft Corp. (MSFT), Texas Instruments (TXN), Target Corp. (TGT), Amgen Inc. (AMGN), even Nike Inc. (NKE) all pay dividends. Even tech superstar Apple Inc. (AAPL) pays a dividend.

Once you get past some of the myths, it’s easy to see that a dividend growth and income investing strategy can generate attractive total returns, a steady income stream for life and protection in market downturns.

My name is Derek Hageman and I’m the financial analyst and editor for AAII’s Dividend Investing premium service. I’m subbing in for Charles this week to share some insights on income investing, specifically on dividend growth and income-focused exchange-traded funds (ETFs).

Generally, dividend funds can be segmented into four groups: growth, income, growth and income and other. Dividend growth ETFs generally focus on finding high-quality companies that not only pay dividends but are also reasonably expected to grow their dividend each year. These funds are less focused on finding the highest dividend-yielding stocks. On the other hand, dividend income ETFs typically employ different strategies to seek stocks with higher yields. Dividend growth and income ETFs use a balance of these two strategies. They seek companies that both have higher-than-average dividend yields and grow their dividends.

Dividend-seeking investors who prefer ETFs may find one or more of these funds to be suitable investments. Deciding which dividend ETF to invest in depends on the characteristics being sought and the willingness to look closely at the strategy a fund is designed to follow.

Spotlight on a Dividend Growth & Income Focused ETF

If the goal is to satisfy demand for balance between potential dividend growth and higher-than-average yield, then dividend growth and income ETFs are what should be considered.

An example is the WisdomTree U.S. LargeCap Dividend ETF (DLN), which seeks to satisfy demand for growth potential and income focus—a growth and income dividend strategy. The fund is classified as a large-cap value equity style. As of February 17, 2021, it held 295 dividend-paying stocks. Qualifying stocks must have an expected regular cash dividend, have a market capitalization greater than $100 million and meet trading liquidity requirements. Unlike some dividend growth focused ETFs, stocks in this fund do not need a long history of dividend payments to qualify for inclusion.

Although the fund doesn’t screen for quality and may own some firms with weak fundamentals, it has limited exposure to firm-specific risk. The top three sectors that make up the WisdomTree U.S. LargeCap Dividend ETF are: technology (20.8%), consumer defensive (15.8%) and health care (15.5%).

The fund weights its holdings by the proportion of dividend payments that each firm is expected to make among all dividend-paying stocks, which tilts it toward larger and more profitable stocks. At the fund’s yearly rebalance, it increases its exposure to stocks that have become cheaper relative to their dividends and trims positions that have become more expensive.

Every stock has a unique profile of value, and its dividend yield (calculated by dividing the indicated annual dividend by the current stock price) can help investors determine how relatively undervalued or overvalued its share price is. Undervaluation is not synonymous with low price; rather, undervaluation occurs when a stock’s price is low in relation to the expected future cash return to shareholders. But there’s an important caveat to be aware of: A stock isn’t necessarily undervalued solely because its yield is high on an absolute basis or even in relation to its historical average. An investor must verify the sustainability of the dividend payment and the financial health of the company.

As you can see in the performance table, the WisdomTree U.S. LargeCap Dividend ETF has a five-year and 10-year annualized return of 12.9% and 11.6%, respectively. The average dividend yield of the stocks in the fund over the last 12 months is 2.74%.

High-yielding stocks can do well in a low-interest-rate, risk-on environment as investors find higher-yielding stocks to be an attractive alternative to bonds. But high yield is also synonymous with higher risk and lower quality in the dividend world, as well as lower expected dividend growth. It is expected that over the long term, dividend growth strategies will outperform high-yield strategies on a risk-adjusted basis.

Successful dividend-paying stocks must possess good business models, strong balance sheets, growth in sales and earnings, positive free cash flow, attractive valuations and a history of rising dividend payments.

The top two holdings in the WisdomTree fund are in the technology sector: Microsoft and Apple. All of the stocks mentioned at the beginning of my commentary are included in this fund.

One of the disadvantages of investing in an ETF is that you have less control of selling (and buying) when circumstances suit you the most. While mutual funds and ETFs afford investors easy diversification, buy and sell decisions are based on money flowing in and out of the fund. Often, that means buying high and selling low. In other words, funds tend to see greater inflows at the top of the market and greater demands for redemptions when the market is falling. However, these actions are counterintuitive, especially for investors who prefer to dollar-cost average. When managing your own portfolio of stocks, you have the flexibility of adjusting your portfolio to better fit your investment strategy and financial needs.

Invitation to AAII’s Income Investing Facebook Group

As investors search for yield in today’s low-interest-rate environment, many are flocking to dividend stocks and ETFs. It’s important to stay informed to maximize your chances at success, and I hope I was able to give you something valuable to think about.

Now, let’s take this conversation to the next level. I have just started up an online club of like-minded income investors, organized to share ideas and advance our collective information and education.

Please do me a big favor and accept my invite to AAII’s Facebook group, Income Investing. Then, introduce yourself and give me your best dividend stock or dividend-focused ETF success story! Or ... tell us what you’ve learned (or would like to learn) as a dividend investor.

Remember ... investing doesn’t need to be a solitary pursuit, and we are all in this together. The AAII Income Investing Community is here to help. See you there.