07) Stock Picking Strategies: Income Investing

by · October 16, 2010

The goal of income investing: pick a stock that provides steady income.  It is perhaps the most straightforward way of picking stocks.  Aside from fixed securities and bonds, stocks can also provide a steady income for investors.  Let us look into the strategy of finding these stocks.

The Dividends

Income investors usually look towards established companies.  These are old, established and reputable.  They have very little room for higher levels of growth and are not in industries that are rapidly expanding.  So instead of reinvesting retained earnings on the company, they pay out dividends to shareholders instead as a means to provide a return.

Dividend Yield

Income investment does not automatically mean that you invest in the company that pays the highest dividend.  You instead take a look at the dividend yield which is the annual dividend per share by share price.  This gauges the actual return a dividend gives the owner of the stock.  Example, a company has with a share price of $100 has a $6 dividend share and a 6% dividend yield or a 6% return on the dividend.  Average dividend yield of companies in the S&P500 is 2-3%.

However, a 2-3% return is not enough for income investors.  They are looking for companies that provide at least a 5% return on their investment.  This means that if a person invests $1M his investment would yield (before taxes) $50,000-$60,000.   The principle behind this strategy is simple: find good companies with high dividend yield and receive a steady stream of income over the years.

Another thing to consider is a company’s dividend policy.  Try to determine whether a company can sustain their dividend yields for the years to come.  If a company suddenly increases the rate of dividends over a short period of time, this might be too optimistic.  A good rule of the thumb:  the longer a company has been paying good dividend, the more likely it will continue to do so.

Johnson & Johnson for example have been paying great dividends and increasing dividend rate over the years.  From 1963-2004, they have been steadily increasing their dividends each year.  If you bought the stock in 1963, your dividend shares would have grown 12% yearly.  In 30 years it would have reached a 48% return on your initial shares!

Critics of the income investing technique say that this strategy is too conservative.

The Downside of Dividends

Dividends aren’t everything.  A high dividend does not mean it’s a good company.  Because dividends come from the company’s net income, it could result to lower retained earnings.  Problem usually develops when reinvesting that money would have been better compared to paying higher dividends.

Income investing is a good stock screener when you want to look for companies with good dividend yield.  Investing on these companies are good especially if they have provide good and sustainable dividend yield.  This is why investors should analyze a company’s fundamentals thoroughly.

Also, dividend yields do not equal low risk.  Risk is still involved especially when dealing with high dividend yields.  This risk can be minimized by picking solid companies.

Dividend yields are also taxable.  They have the same rate as your salary. Therefore these are taxed higher than capital gains which can make your final cut a bit lower than originally expected.

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