Our team of professionals has assembled a comprehensive guide about income and dividend stocks. It includes information such as their main characteristics and risks, while also providing real examples, as well as advice on how to spot and successfully invest in them.
Income Stocks Definition
Dividend or income stocks are shares of publicly listed companies that pay a regular, and sometimes increasing dividend. Generally, they reward investors with higher dividend yields than the market average. In addition, income and dividend stocks usually have lower volatility than the overall stock market.
In many cases, companies that pay high dividends focus on rewarding investors this way, as they have limited capital gains opportunities. This is because these firms operate in mature business lines, where there are few available prospects for growth and investment. However, this is not always the case, as some companies, especially from the oil & gas sectors, need to invest large amounts of capital in the following years for a transition towards a carbon-free economy.
Dividend stocks are best suited for investors that are looking for a passive source of income, more exactly, income from stocks. They are especially sought after by investors with lower risk appetites, or those that do not earn a stable salary and are looking for an alternative source of income. However, they should be part of a mix of fixed income securities, such as bonds and Treasury bills, in order to enhance and diversify any trader’s portfolio.
Two main types of income stocks are available for traders:
- Common stocks – These are ordinary shares of publicly traded companies that pay competitive dividend yields, while historically keeping a stable stock price;
- Preferred stocks – They are also known as fixed-income stocks, and are hybrid securities, which are more similar to bonds, rather than stocks. These instruments reward investors with a fixed dividend payment, regardless of the firm being profitable or not. Preferred stocks offer a higher claim on distributions (dividends) when compared to common stocks. However, in many cases, these types of stocks do not offer voting rights to their holders.
Characteristics of income stocks
Competitive dividend yield
Investors looking after the best income stocks should try to pick the ones that offer a competitive dividend yield. This means that a company has to offer a higher-than-average yield and increase it regularly, in order to hedge against inflation. Otherwise, investors will try to find better alternatives, as their overall returns are impacted by inflation.
Exxon Mobil (XOM), the biggest oil producer in the US, has offered traders dividend increases for the past 37 consecutive years, with an average annual rate of 6.2%. This strong dividend policy has protected its stockholders from inflation, which was always surpassed by the increase in dividends.
Regular dividend payments
Traders seeking to purchase the best stocks for income should look after companies that have a stable dividend policy. This is a strong indicator that highlights the financial position of a company, as not all firms can afford to keep their dividend payments during market downturns or when they invest in expensive projects. A regular and predictable dividend level boosts investors confidence in the firm while increasing demand for the stock.
A good example of dividend stocks is Caterpillar (CAT), the biggest producer of heavy construction and mining equipment in the world. This company offered its investors regular and uninterrupted dividend payments since 1933.
Good for diversifying and enhancing fixed income portfolios
Dividend stocks allow traders to diversify their fixed income portfolios, offering them an asset with a better return than traditional instruments, such as bonds and treasury securities, can provide. In addition, they can represent a significant portion of any stock portfolio, as they offer more stability to it during market fluctuations, by reducing its risk (Beta). This is because many income stocks are usually regarded as defensive stocks by traders, as they come from industries such as electricity, utilities, food and beverage.
Lower volatility than the stock market
In most cases, some of the best stocks for dividend income have lower volatility than the stock market average. This means that, when compared to other stocks, the share prices drop less in an economic downturn, but rise to a lower level during market expansion. In order to quickly find such as company, traders should look for stocks that have a low Beta (less than 1).
A good example is the London Stock Exchange Group plc (LSE: LSE.G), which has a Beta of around 0.6. This made the firm to have fewer price fluctuations that other stocks in the FTSE100 in a turbulent 2020.
Stable cash flow
Investors that want to purchase income stocks should look after firms that had a stable cash flow in the past years. This is a sign that the company has solid earnings from which it can choose to reward shareholders, and that it operates in a business line with smaller volatility.
Large market cap
Firms with a large market capitalisation tend to reward investors with good income from dividends. This is primarily because their business and financial position is solid, providing them with enough money to cover operations and investments while maintaining a sufficiently high profit margin to allow dividend payments.
Companies that are at a mature stage of their development tend to offer high yield dividends to stockholders. This is partly due to the fact that there are fewer investment opportunities available for them to engage in, and thus, limited future growth options. Consequently, there is a good amount of disposable earnings available for pay-out.
How to find an income stock?
Firstly, traders that want to invest in income and dividend stocks should filter companies by selecting those that offer a higher-than-average dividend yield, and those that have a Beta of less than 1. Secondly, they have to see if the dividend policy was constant in the past years and if there were increases in the dividend payments in order to match the inflation rate. Alternatively, traders can also look after companies that operate in defensive industries such as utilities, energy, healthcare, and discount retailers.
Moreover, investors that are looking to purchase income and dividend stocks in 2021 should be cautious, and keep a close eye on company annual reports, as many firms had seen a downfall in their revenues and profit due to the Covid-19 pandemic. As a result, traders should keep in mind that the main benefit of investing in income stocks is represented by the attractive dividend policy. Maintaining such a policy can be a challenging task even for companies consisting the best dividend and income stocks available, as some struggled in 2020. This is especially important for investors that want to earn a monthly income from stocks.
For example, Carnival Corp (NYSE: CCL), one of the largest cruise operators in the world, has announced a dividend suspension for the whole of 2020, with strong prospects to continue in 2021. Before the economic crash caused by the medical crisis, the firm was rewarding investors with a comfortable annual yield of 4-5%.
Investors must know that between stocks with the same dividend yield, companies that pay dividends more often than once a year (bi-annually, quarterly, or even monthly) are more valuable than firms which make a single yearly payment. This is because traders that hold stocks of companies that make multiple dividend payments over the year can access their money faster, giving them the option to reinvest it and increase their returns.
For example, STAG Industrial (STAG), a real estate company specialised in industrial buildings rental, offers traders a solid 4.7% dividend yield, which is paid monthly. As a result, a skilled trader could use that money to reinvest in other securities over the entire year, having the chance to obtain a higher return than from a stock which they would have to hold for up to a year.
Risks of investing in income stocks
Dividend stocks can be easily influenced by sectorial risks. This can have both a positive and a negative outcome for investors. For example, when oil prices go down, firms that operate in the oil sector can choose to reduce their dividend payments, as they have lower revenues and profits.
Royal Dutch Shell (RDS.A), the energy giant, had to reduce its dividend payments by 66%, due to a drop in oil prices and demand. Other firms in the industry, such as British Petroleum (NYSE: BP) and Total (EPA: FP), are expected to follow this move.
Decline in value when interest rates rise
Dividend stocks are becoming less attractive for investors when interest rates rise, as other fixed-income assets, such as bonds, can be more sought-after. Therefore, traders are ready to purchase bonds if they offer a higher interest rate than the dividend yield, and vice-versa. This can lead to a drop in the share prices and negatively impact a trader’s portfolio. The phenomenon usually occurs during market crashes, when companies have lower profits, and thus less cash to pay as dividends to investors.
Low capital gains
Investors looking to buy dividend and income stocks must be aware that generally, they offer little if any, capital gains. This is because these firms either operate in a business with lower needs of capital investments, or they issue too large dividend payments, negatively impacting future growth opportunities. As a result, there are low prospects for capital appreciation, especially if the traders buy the shares during market expansion.
More expensive share price
In a slow-growing economy, traders are actively seeking to purchase dividend stocks, which can lead to a rise in their price, thus reducing their dividend yield. As a result, they should be avoided by traders that have limited investment possibilities.
Loss of competitive advantage
Firms that reward investors with high dividend returns can risk losing their competitive advantages as compared to companies in the same industry that offer lower returns. This is can happen because less cash is left in the company to invest in its future operations. As a result, this can impact the business in the long term, potentially disrupting future dividend payments.
An inflation that constantly exceeds the rate at which dividends are increasing can represent a serious problem. This is especially important for investors that rely on income from stocks, as it erodes the returns they use to pay for their daily expenses.
To sum our guide up, we’ve created a checklist for identifying income and dividend stocks as well as a list of current examples.
Criteria for spotting income and dividend stocks
- Constant increase of the dividend per share (DPS) ratio;
- Beta lower than 1;
- Stable cash flow;
- Mature company;
- Regular dividend payments;
- Constant increases in dividend payments (preferably above the inflation rate);
- Yield higher than the prevailing 10-year T-bond;
- Company operating in a defensive industry;
- Preferably dividend payments take place bi-annual, quarterly, or even monthly;
Examples of income stocks
- Walmart (NYSE: WMT)
- McDonald’s (NYSE: MCD)
- AT&T (NYSE: T)
- Shell (AMS: RDSA)
- London Stock Exchange Group (LSE: LSEG.L)
- STAG Industrial (NYSE: STAG)
- Caterpillar (NYSE: CAT)
- Chevron (NYSE: CVX)
- Linde (NYSE: LIN)
- Exxon Mobil (NYSE: XOM)