Many individuals consider investing in individual companies in the stock market to be too risky and dangerous to do on their own. So they rely instead on “safer” professional alternatives such as financial advisors and the mutual fund industry.
Unfortunately, the track record of most professional money managers and advisors is none too great owing to a number of factors that include: over trading, having too much money to efficiently or effectively manage, over diversification, and too much reliance upon conventional wisdom regarding asset allocation.
The good news for motivated self-directed investors is that real investing, specifically via high quality dividend paying companies, is both straightforward and rewarding. Here then is a 5 step formula for successfully building wealth and cash flow with dividends.
Choosing High Quality Dividend Paying Companies
The best dividend investments are rarely those with the highest yields or biggest payouts. The number one rule of dividend investing is to not be seduced by high yield. Dividends represent your portion of a company’s earnings returned to you in the form of cash. As such, dividends must be based on reality and sustainability, and not on deteriorating fundamentals.
The most important criteria when considering an investment is the quality of the underlying business itself. This is such a simple concept, but most people have either forgotten it or never even considered it in the first place so that it now seems either radical or naive.
You should approach stock selection with the same seriousness and rigor as if you were actually buying a business because, interestingly enough, that is precisely what you are doing. So why would you ever invest in anything less than the highest quality companies that you can identify?
The Power of Dividend Growth
Few individuals really grasp the profound power of dividend growth investing. As a dividend-paying company and its earnings grow over time, those dividend payouts regularly increase as well. This is called, naturally enough, dividend growth.
There are many examples of companies increasing their dividends consecutively for the last 10 years, 20 years, 30 years, and even longer.
The power of dividend growth isn’t that a single increase in a quarterly dividend will make you rich, but rather the cumulative impact of increasing dividends over time has a powerful compounding effect.
An example: Say you bought $100,000 worth of shares in a high quality, dividend paying company with a current 3% dividend yield, meaning that you would receive $3000 a year in dividends. And let’s also say that the company continues to raise its dividend by 10% each year.
After 2 years, you would receive $3300 in dividends; after 3 years, you would receive $3630; after 4 years, you would $3993; and after 5 years you would receive $4392.30.
But here’s where the compounding effect takes place. In Year 2, the company increased its dividend distribution by 10% and you received an additional $300, which also represented a 10% increase. But by Year 5, the company’s 10% annual increase from the previous year is an additional $399.30, which for you actually represents a 13% increase based on your initial investment.
And that’s only after 5 years – this number and the compounding effect will only increase over time.
If you reinvest the dividends you receive by using those dividends to purchase additional shares of the stock, you further accelerate the compounding effect. Many companies offer commission free dividend reinvestment plans (called DRIPs) directly to investors and most online brokers offer comparable commission free reinvestment services as well, so this is a realistic and accessible strategy to pretty much everyone.
When you reinvest your dividends, those dividends purchase additional shares that, in the next quarter increases the total amount of dividends you receive which in turn purchases additional shares that in the next quarter again increases the total amount of dividends your receive which in turn… you get the idea.
Again, stock selection is paramount. Reinvest in a low quality, high dividend stock and you could still wind up with nothing.
The first 3 steps represent a proven investing method that builds both wealth and cash flow over time and in any market. All it takes is time and patience.
I have found, however, that by adopting certain conservative and customized option trading strategies (which I’ve termed, “Leveraged Investing”) that this proven investing approach can be accelerated. This allows the investor to reap the proven benefits of dividend investing more quickly and to a larger degree.
The goal of, and rationale for, Leveraged Investing is to use options intelligently to generate a continual reduction in the cost basis of one’s long term holdings (rebates, if you will) which provides yet another source of funds that can be reinvested back into the acquisition of additional shares.
The final element in successfully using dividends to build real wealth and a powerful cash flow is to be patient. The best investments tend to be boring investments. Certainly you need to monitor your investments, but if you’ve done your homework and really chosen consistently profitable and durable businesses, your best strategy will most likely be to simply sit back and wait.
In that regard, Leveraged Investing has an additional benefit for those who find it difficult to keep their hands off their own portfolios, namely that it gives them a little something extra to do and look forward to. Though not particularly difficult or time consuming, using options conservatively and intelligently to provide your portfolio with an additional investment edge can be as stimulating as it is rewarding.
Brad Castro is a practitioner and promoter of Leveraged Investing, or option trading techniques and strategies designed to simulate successful value investing. Leveraged Investing has two objectives: to acquire stock in quality companies as cheaply as possible and then to squeeze more returns from those stocks once they’ve been acquired. Article used with permission.