Many dividend-paying stocks have held up well this year as the major indices entered a bear market. Contrary to conventional wisdom, the opportunity still exists for investors to create a reliable stream of income from the equity markets. One of the best ways to increase returns is to compound dividends received. Over time, reinvesting dividends and distributions can have a significant impact on overall portfolio returns.
Dividends are a fantastic way to generate sizeable returns from stocks. I prefer to target companies that have a history of raising dividends, even during uncertain times such as the current market environment. I have found the dividend growth rate to be a reliable forecaster of future earnings growth. A consistently rising dividend trend subtly reveals a company’s progress and is one of the best indicators of a healthy, growing business.
In my experience, the following three types of dividend-related investments provide the best returns over time:
• Leading dividend-paying stocks (Dividend Achievers)
• Master Limited Partnerships (MLPs)
• Real Estate Investment Trusts (REITs)
Let’s examine each investment vehicle in more detail.
1) Dividend Achievers
Dividend Achievers are companies with a history of increasing dividend payouts. These companies are committed to enhancing value through the return of capital to shareholders. A Dividend Achiever is generally considered to be a company that has increased its dividend each year for the last ten years.
The actual dividend yield is not necessarily as important as the growth rate of dividend increases. For example, a stock that is currently paying just a 2% dividend yield – yet increases that dividend an average of 20% per year – will be yielding 10.3% on the original investment after ten years (+415% total increase in yield). This is due to the magic of compounding.
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Corporate directors know their companies better than anyone else. They know the financial condition of their business, along with the outlook for its future earnings growth. They will only raise dividends if they truly believe that future earnings will be able to sustain higher dividend payouts. Using this simple yet effective strategy of investing in companies that consistently raise their dividends, investors can harness the power of compounding income.
Continued . . .
It Just Makes Sense
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2) Master Limited Partnerships (MLPs)
Due to their favorable tax treatment, this type of high-yield, high-quality investment vehicle has been providing investors with favorable returns for many years. There are countless and relatively unknown MLPs that have consistently raised their dividends over a long timeframe, providing investors with high returns. MLPs do not pay income taxes and they trade on major stock exchanges.
MLPs are different than other traditional investment structures – they are partnerships. A general partner is responsible for running the MLP, and individual investors serve as the limited partners. MLPs must pay their profits directly to shareholders and pay much bigger dividends because they pay no tax. The income generated from the MLP is allocated amongst all partners in proportion to their ownership interest.
Compared to dividend-paying stocks, MLPs are relatively unknown and are largely ignored by the financial media. MLPs are able to sidestep the IRS and pass their earnings directly to shareholders making them the ideal investment for individual investors.
Investing in MLPs also comes with a special tax benefit for MLP dividends which are referred to as distributions. The IRS considers 80-90% of MLP distributions as a return of capital, which means investors can defer taxes on their gains for many years until they sell their shares. MLPs have attracted a diverse set of companies in many industries due to their favorable tax treatment.
3) Real Estate Investment Trusts (REITs)
Real estate investment trusts continue to be a great way to balance your portfolio while gaining exposure to the real estate sector. Adding these incoming-producing investments can result in significant advantages over traditional real estate investing including increased liquidity, greater diversification, tax benefits and potentially higher returns with lower risk.
Real estate investment trusts either own or manage income-producing real estate, normally through directly investing in properties or the mortgages on those properties. Like MLPs, the IRS mandates that REITs must pay out 90% of their taxable income to shareholders. This typically translates into much higher dividends than your average S&P 500 stock.
Investors have the option to buy REITs directly, or may choose to further diversify by investing in REIT ETFs or mutual funds. REITs not only offer above-average yields, but also the potential for future price appreciation. Investors have turned to vehicles like REITs when searching for ways to increase yield.
While REIT prices may react in the short-term to changes in the outlook for interest rates, over longer periods there is typically a positive correlation between rising rates and REIT returns. A stronger economic backdrop normally leads to higher occupancy rates, increased NOI (net operating income), and expanding property values. All of these components lead to higher dividend payments for REIT investors.
I think dividend-paying stocks are more important than ever, particularly in this highly inflationary environment. With the corporate earnings outlook uncertain at best, these steady, income-producing equities with strong balance sheets and a history of raising dividends are an investor’s best friend. Compounding returns using the dividend strategies we mentioned above is a great long-term approach to building wealth.
Easiest Way to Use These Strategies
There is a tremendous amount of financial spin out there in the media, so I recommend using proven strategies with an actual history of profitable results. The best way to evaluate any investment methodology is to look at verified results.
That’s why I invite you to check out our Zacks Income Investor portfolio right now.
In the past year, we’ve closed out major gains such as a +188.3% winner in a domestic real estate investment trust (REIT), as well as a +150.9% return in an aerospace and defense company. Our top holding in the present is a leading company in the steel industry which is showing another tremendous gain of +191.8%.¹
This year, Income Investor currently has open trade results displaying an average return north of +32% across more than 20 holdings, with an average dividend yield of +3% and an astonishing 88% in the green. Keep in mind, these results were achieved during one of the worst starts to a year in market history. At the time of this writing, the Nasdaq is still off greater than -20% from its peak last November, while the S&P 500 has fallen more than -13% this year.
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This demonstrates the Income Investor’s ability to produce substantial gains even during bear markets.
Investors in our service have received significant price appreciation, in addition to a dividend that makes what savings rate banks are offering look like the slap in the face that they are. If the Income Investor service can produce these types of results during economic uncertainty, imagine what it could do once the market turns the corner.
That’s why I wholeheartedly believe that dividend investing is an ideal strategy for today’s volatile markets and uncertain economy.
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Wishing You the Best on Your Investing Journey,
Bryan Hayes, CFA is a Strategist with Zacks Investment Research and invites you to take advantage of the highly successful portfolio he’s directing – Zacks Income Investor.
¹ The results listed above are not (or may not be) representative of the performance of all selections made by Zacks Investment Research's newsletter editors and may represent the partial close of a position.