Stock investors derive their profits from dividend income and capital appreciation. Capital appreciation is the primary source of stock profits, but skilful investors can generate decent profits from successful dividend investing.
Some companies increase dividends over time. When the dividend increases, the stock becomes more valuable to investors who are willing to pay more for it, and their buying pushes up the stock price. Investors who own stocks that increase dividends over time, in effect, own an appreciating asset that produces more income. For example, XYZ is paying a $1.28 per share annual dividend and is currently selling for $42.67 a share, giving it a 3 per cent dividend yield. XYZ increases its dividend by 10 per cent to $1.41 per share. If the market thinks that a 3 per cent dividend is reasonable, the stock price will increase to $47 a share to maintain the 3 per cent yield — a corresponding 10 per cent increase.
The process of paying a dividend has several stages: a board of directors declares a quarterly dividend and sets dividend record and payment dates, which may be a month or more apart; record date establishes who is entitled to receive the dividend; the payment date is when the dividend is actually paid to the shareholders of record. To facilitate trading, brokers also set an ex-dividend date. Investors who buy a stock prior to the ex-dividend date will receive the dividend. Some investors buy stocks shortly before and sell them shortly after an ex-dividend date, just to collect the dividend, and repeat this process with multiple stocks up to four times a year.
In his book “Beating the Dow” Michael O’Higgins set out the”Dogs of the Dow” strategy that became popular throughout the 1990s. According to O’Higgins, if an investor had bought the five or 10 highest yielding stocks of the 30 stocks that comprise the Dow Jones Industrial Average and held them for a year, he would have outperformed the average in most years. After holding “the dogs” for 12 months, he would move his capital into the then highest yielding stocks and repeat the process. The strategy was called “the dogs of the Dow” because a higher dividend is the function of a lower stock price: buying the highest yielding stocks and selling them after the yield has come down constituted a classic “buy low, sell high” approach. The strategy largely stopped working when too many investors started using it, buying and selling “the dogs” all the time, however, some investors still follow the same principle, applying it to other dividend-paying stocks.
Dividend reinvestment is buying more shares with the dividend instead of taking it in cash. Dividend reinvestment is not a style per se as it can be used with any of the above methods, but it is a powerful tool to enhance long-term returns through compounding.