The buying and selling of dividend-paying stocks are worldwide very popular. A dividend payment is mostly periodical, a payment from the company to its current shareholders. Most of the times this is done 1 x per year. But in the US this frequency is higher. The ex-dividend day is the day the investor has to own the shares in order to be entitled to receive the dividends.

As an example, let's say the Citigroup share is now trading at USD 30 and will pay 1 dollar dividend next week, then normally at the ex-dividend date the share drops 1 dollar. For investors living in Belgium we offer the Belgian website with dividend information. So that 1 dollar which will be received by the shareholders is not available for the shareholders who didn't have the share at the ex-dividend date. On balance we call this a zero-sum operation. So what does it matter in the end if we buy dividend-paying stocks or not if it's a zero-sum on the short term? In the short term, there is no reason to buy dividend-paying stocks at all.

The reason for it is information about dividends is most of the times very well processed by the markets (market efficiency). So a higher or lower dividend is totally not relevant as the markets discount this information.

Why we prefer dividend stocks

Why would it be relevant to buy shares that pay out dividends? When looking back at the long history we see quite a huge outperformance by the dividend paying companies versus the companies that didn't pay out dividends.

The capability of being able to pay out dividends can be seen as a quality indicator. In case a company doesn't payout dividends could mean it's just capable / doesn't earn enough. You can see the capability of being able to payout dividends as a kind of quality indicator.

Of course, this is very short-sighted as there are many other variables that influence the company's quality (read: under- or overpricing). When we look at the short term we don't see any differences between the dividends are paying and non-dividend paying companies. But when we look at the long-term we see higher total returns (price returns + dividend returns) for the companies that paid out dividends. This is mostly caused by the interest-effect. This is an exponential effect caused by the re-investing of dividends. This creates a kind of snowball effect.

You can see it like a young tree that gives more apples after the time passes. The famous Albert Einstein called this interest to affect the 8th world wonder. Famous dividend investors are Mark Cuban, Richard Russel and T. Boone Pickens.

Dividend taxes

Dividend tax is the part that is kept by the governments. Mostly investors can restitute a part of this back. One of the reasons for taxing dividends separately is to prevent tax avoidance: in a system, without dividend taxes, it is possible to have money streams via the dividend payments in order to avoid the income taxes. For foreign investors, it's mostly only interesting to try to restitute all of the dividend taxes as the cost of restituting it is very high.

This is caused by the very high administrative costs which are normally way higher for the general investor than the withheld dividend taxes. Normally the breakeven point is around 250 dollars. This means in case your withheld dividend taxes are less than 250 dollars it makes no sense of claiming it back.

Dividends vary

Dividends are never stable and vary throughout the time. Companies can easily announce to stop paying dividends to its shareholders. These insecurities almost always have big impacts on the share price.

When a company says it will decrease her dividend we almost always see direct responses at the financial markets. Of course, this is because that current shareholders will earn less (they receive less or no dividends). So in case, there are dividend adjustments we almost always see this back at the stock and options exchanges (in case options are listed on the share).

Watch out for the value trap

The investing based on a dividend strategy is all but an easy strategy. Historical dividends are just historical data and hardly say something about the future. This also because of the market efficiencies. For investors is absolutely relevant to focus further than just the dividend yield in order to avoid the value trap.

The focus on just high dividends could probably end up in a portfolio with low-quality companies. It's crucial that investors have a total picture of a company's most relevant financial variables. Can the company afford to pay out the dividend is the big question.

Import financial variables that influence the company's financial position are the cash position, solvency, profitability, cash flows et. Of course, these variables are itself also unpredictable so it's very hard the stability of a company's dividends.

Don't go for the highest dividend yields

It's very logical just to hunt for the companies that pay out the highest dividends but it's not that easy. A dividend yield of let's say 6 percent is very rare and also quite dangerous. With this we mean that the effective dividend yield is way too high: either the dividend per share is too high or the stock price is just too low.

Both are possible but in the financial markets, you never know it. There are lots of examples of famous companies that had high expected dividends but needed to lower or even stop them and go bankrupt.

Think of for example MF Global Holdings, Capmark Financial and Chrysler. Most of these shares had very high expected dividends and so extreme dividend yields. But when these dividends per share were lowered or even stopped the stocks crashed. And for most of them even further crashed after announcing the redemptions of the dividends.

The height of the expected dividend per share is nothing more than the consensus of the analysts. Of course, companies also provide news about their future dividends but the current shareholders always need to agree with that at the general stockholder's meetings. But in practice we rarely see it happen that current shareholders propose a lower dividend per share.

Dividend Aristocrats

Dividend Aristocrats are these companies that always have raised their dividends each year in their history. Of course, this total number is getting smaller and smaller each year. Famous dividend aristocrats are T. Rowe Price, Family Dollar Stores and Franklin Resources.

The returns of most of these companies had been magnificent in history. This is partly caused by the interesting effect (the re-investing of received dividends). But please don't focus too much on this.

These are just past figures, performances, returns, data etcetera and don't tell us much about the future. In the end, there is no company that can ever keep on raising her dividend. So forever rising dividends are a fairy tale. But the Dividend Aristocrats' long-term performance clearly points out the positive effects of the re-investing of dividends.

Author's Bio: 

Muhammad Nasir Aziz is a professional financial Journalist at Value Spectrum. He has more than 4 years’ experience in writing articles on finance, business and cryptocurrency. In the past, he was working for Stocks Reporters. He has a great interest in writing and reading articles on finance.