Automatic Income

by Matthew Paulson

  CHAPTER TWO

  Dividend Investing Basics

  Let’s imagine for a moment that you have a friend named Michaela and that she is starting a new company that will offer customized IT solutions to other small business. Michaela needs some money to get her business off the ground. She approaches you and offers to sell you a 25% equity stake in the business in exchange for $50,000.00. You want to help out Michaela and think her business has merit and could generate significant profits, so you decide to take the deal and invest in her company. You are now a minority partner in an IT consulting business. You don’t take home any profit for the first year, but Michaela’s company starts to generate some meaningful profit during the second year.

  Michaela decides that she doesn’t need to keep all of the money in the business and declares a dividend at the end of the year. As a 25% owner in the business, you are entitled to receive 25% of the dividend that is paid out. Michaela mails you a check for your share of the company’s dividend at the end of the year and continues to do so as long as the company makes money and you remain a shareholder of her company. This is dividend investing in action.

  It’s easy to think of stocks, dividends, and other financial concepts as abstract terms that have no relation to the real world, but owning shares of a publicly traded company isn’t that different than investing in a friend’s business.

  If you were to buy shares of Coca‑Cola, you would become a minority owner of that company. Your ownership interest is equal to whatever percentage of the outstanding shares that you own. You and the other shareholders of Coca‑Cola vote to elect a board of directors, which is responsible for overseeing the affairs of the business each year at the company’s annual meeting, either in person or online through proxy voting.

  When Coca‑Cola makes a profit, the board that you helped elect can decide what to do with the money at the end of each quarter. They can hold on to it as retained earnings. They can reinvest it into the business or they can decide to return it to their shareholders in the form of a dividend payment. When Coca‑Cola’s board of directors decides to distribute part of the company’s profit in the form of a dividend, you are entitled to your share of the profit distribution as a part‑owner in the company. On the date set, your dividend payment will be routed to the brokerage account where you own the stock, at which point you can reinvest the dividend payment to get more shares or spend the money however you like.

  How Dividend Payouts Work

  One might think that it would be easy to determine which shareholders are entitled to receive a dividend payment, but hundreds of millions of dollars in shares of every large‑cap company are bought and sold every day and it’s not always intuitive about who should receive a dividend payment. For example, if you owned shares of Coca‑Cola and I bought them from you after a dividend was declared, but before it was paid out to shareholders, which one of us should receive the dividend? Obviously, this isn’t the first time this question has been asked. There are a number of important dates to be aware of whenever a company announces a dividend:

  Declaration Date – The dividend declaration date is simply the date that a company’s board of directors publicly announces an upcoming dividend. This date has no impact on who receives a dividend payment.

  Ex‑Dividend Date – The ex‑dividend date is the day on which any new shares that are bought or sold are no longer eligible to receive the next scheduled dividend. If you want to receive a company’s next dividend payment, you must buy your shares prior to market close on the day before the ex‑dividend date. Having an ex‑dividend date a few weeks before a dividend is payable makes it easier for a company to reconcile which shareholders are eligible to receive a dividend payment.

  Record Date – Shareholders must properly record their ownership on or before the record date (or date of record) to receive a dividend payment. Shareholders who don’t register their ownership by this date will not receive a dividend payment. In the United States and most other countries, registration is automatic and not something you need to worry about.

  Payable Date – This is the date when dividend payments will actually be mailed to shareholders or credited to their brokerage account.

  A Note About “Dividend Capture” Strategies

  Since the only date that matters when determining who receives a dividend payment is the person who owns it at the end of the ex‑dividend date, one might think it would be easy to game the system by only buying shares of companies going ex‑dividend the following day, holding them for 24 hours, then selling them to receive a dividend payment without actually having to hold on to the stock. You could then buy shares of new companies every day and capture as many dividend payments as there were trading days in a month. This “dividend capture” strategy sounds like a great idea in theory and there are people who have actually tried to teach it as an investment strategy, but it almost never works in practice.

  When a company goes ex‑dividend, its stock price will generally decrease by a dollar amount roughly equivalent to the amount of the dividend paid. Companies do not explicitly take any action to lower their share prices because buyers and sellers will automatically price in the lack of the upcoming dividend into the company’s stock price. These natural adjustments prevent people from trying to game the dividend system and capture dividend payments without owning a stock for more than one day at a time. Dividend capture strategies are very difficult to time correctly, rarely ever work, and are not something that I would recommend that you try to pursue.

  Why Companies Pay Dividends

  Companies that are growing rapidly generally don’t pay ­dividends, because they want to put most of their cash flow from earnings back into growing the company. Fast‑growing ­companies may use earnings to start a new division, purchase new assets, buy out another company, or fund other growth projects. For this reason, many technology companies including Amazon and Alphabet (Google) don’t pay dividends. Additionally, companies that are more established may not pay dividends if they believe that they can create more shareholder value by reinvesting their earnings than by paying a dividend. This is the reason why Warren Buffet’s company, Bekrshire Hathaway, does not pay a dividend. On a side note, Berkshire Hathaway does invest in a variety of dividend‑paying stocks, such as Coca‑Cola, General Motors, IBM, and Wells Fargo.

  Established companies with mature business models generally do not need to reinvest their earnings at the same rate that high‑growth companies do. When a mature company finds itself with excess earnings, it may return a portion of those earnings to their shareholders in the form of a dividend. Many investors like the steady income that dividend‑paying stocks offer and see dividend payments as a sign that the company is strong and that management believes the company will continue to have solid future cash flow. Mature companies will often pay dividends to attract new shareholders, to create greater demand for their stock, and to drive up the price of their stock.

  Regular vs. Special Dividends

  There are two general types of dividend payments. Regular payments are made on a set schedule, such as every month or every quarter. Most publicly traded companies will pay dividends every quarter, but some stocks, ETFs, and mutual funds will pay monthly. Some international companies only pay dividends once or twice per year. The amount of a regular dividend payment is generally pretty consistent from quarter to quarter, unless a company decides to raise or lower its dividend because of changes in earnings and cash flow. Almost all of the dividends that you receive will be regular dividend payments. Special dividends are one‑time payments made to shareholders when a company finds itself with excess cash or disposes of an asset. For example, Microsoft issued a one‑time special dividend of $3.00 per share in 2004 as a way to relieve its balance sheet of a large cash balance.

  Types of Dividend Payments

  Most dividend payments are provided to shareholders in the form of cash, but there are actually several different types of dividend payments.
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br />   Here are some of the different types of dividend payments that you may run into as an investor:

  Cash Dividends – These are by far the most common type of dividend and will account for the vast majority of the dividend payments you receive. Cash dividends are simply a transfer of your share of a company’s earnings to your brokerage account in the form of cash.

  Stock Dividends – A stock dividend is the issuance of new shares of stock to existing shareholders without any consideration (payment) provided in exchange for the new shares. For example, if a company declared a 5% stock dividend and you owned 10,000 shares, you would receive 500 new shares of the company. While stock dividends increase the total number of outstanding shares of a company, they don’t increase the value of the company. A company that has a market cap of $1 billion isn’t suddenly worth $1.05 billion just because they issue a 5% stock dividend. Effectively, a stock dividend is a minor form of a stock split designed to increase the number of outstanding shares in the market.

  Property Dividends – Companies may issue non‑monetary dividends to their shareholders. A property dividend could come in the form of shares of a subsidiary company or be physical assets such as inventories the company holds. For tax purposes, property dividends are recorded at the value of the assets provided to shareholders.

  Scrip Dividends – When a company does not have enough money to make its dividend payments, it may issue a scrip dividend, which is effectively a promissory note to pay shareholders a cash dividend at some date in the future.

  Liquidating Dividends – A liquidating dividend is a return of the capital that was originally contributed by shareholders. This type of dividend often occurs when a company is getting ready to shut down their business.

  As a dividend‑stock investor, almost all of the dividend payments you will receive will be simple cash dividends. It is also possible that you will receive a stock dividend if a company wants to increase the number of shares it has in the marketplace without doing a full‑on stock split. You may receive a property dividend if a company is spinning out a subsidiary as an independent company. Scrip dividends and liquidating dividends are very rare and you are unlikely to receive them as a dividend‑stock investor.

  Types of Dividend Stocks

  When we think of a dividend‑paying stock, we generally think of established blue‑chip companies such as Johnson & Johnson and General Electric. There are actually many different types of dividend‑paying publicly traded companies that operate in different industries, have different corporate structures, have different tax liabilities, and have other characteristics that you should be aware of. The next several sections of this chapter outline some of the major categories of dividend‑paying stock that you might choose to invest in. The tax treatment for each of these types of stocks is discussed in a later chapter.

  Consumer Staples

  Companies that sell products that consumers use from day‑to‑day, such as beverages, household products, personal products, and tobacco are labeled as consumer staples. Proctor and Gamble (PG), Coca‑Cola (KO), Philip Morris (PM), and Unilever (UN) are examples of consumer‑staples companies. Consumer‑staples companies sell products that are non‑cyclical, meaning that consumers still generally need to buy their products during an economic downturn. As a result, these companies tend to have relatively consistent earnings and cash flow. These companies also tend to be very well established and have large market caps as a result of consolidation that has happened over the years, which makes them perfect candidates to pay dividends.

  Banks

  Many large banks were established dividend payers that offered yields between 3% and 5% before the Great Recession. When falling asset prices wreaked havoc on their balance sheets in 2008 and 2009, almost all of them had to dramatically cut their dividends. Since then, many of the large banks have slowly started raising their dividend payments again. Many are currently paying dividend yields between 1.5% and 3%. There are a few banks, most notably Wells Fargo, that are beginning to pay dividend yields that are consistently higher than the S&P 500. At this point, it’s hard to say whether or not banks as an asset class will return to their former glory of being high‑dividend payers.

  Energy Companies

  Large‑cap energy companies, like British Petroleum (BP), Chevron (CVX), and ExxonMobil (XOM), have a history of paying strong dividends. When energy prices are low, as they have been in the last year, these stocks’ share prices take a beating and their dividends rise. As I write this chapter, crude oil is hovering around $45.00 and major energy companies are paying dividend yields between 4% and 7%. When oil prices increase at some point in the future, oil producers’ stock prices will rise in tandem and their dividend yields will decrease to their more historic range of 3% to 5%.

  Master limited partnerships (MLPs) are a subset of energy companies that are structured as publicly traded limited partnerships. Investors who buy units (shares) of MLPs become limited partners in the business and the company is run by its general partners (the company’s management). The MLP structure is used almost exclusively for energy and utility companies. MLPs have some unique tax advantages because of their corporate structure, which are explained in detail later on in this book. MLPs tend to own energy pipelines and terminals, which makes them less sensitive to energy prices than large‑cap energy production companies are. MLPs tend to have strong and consistent cash flow, which allows them to pay above‑average dividends. It is not uncommon for MLPs to have dividend yields between 5% and 8%. Examples of MLPs include Spectra Energy Partners (SEP), Magellan Midstream Partners (MMP), and Enterprise Products Partners (EPD).

  Royalty Trusts

  Royalty trusts, like master limited partnerships, invest in assets in the energy sector. Royalty trusts generate income from the production of natural resources like coal, oil, and natural gas. Royalty trusts have no actual employees or operations of their own. They are simply publicly traded financing vehicles that allow large energy production companies to lease natural resource assets. Royalty trusts are operated by banks, which manage their financial interests, take care of their paperwork, and make distributions to shareholders. Royalty trusts’ cash flow and distributions can swing wildly as commodity prices and production levels change, which causes them to have very inconsistent earnings from one year to the next.

  The largest royalty trust in the United States is the San Juan Basin Royalty Trust (SJT), which owns oil and natural gas resources in the San Juan Basin of northwestern New Mexico. It is operated by Burlington Resources, a privately held oil‑exploration‑and‑production company. Burlington Resources pays production royalties to SJT, which are then paid to shareholders of SJT in the form of distributions. SJT is managed by Compass Bank, a subsidiary of BBVA.

  Many royalty trusts pay very high dividend yields, often in excess of 10%. Royalty trusts also have some unique tax benefits, which are described in detail in Chapter 5. While royalty trusts pay high yields, remember that the distribution payments they make are tied directly to the underlying price of the commodity owned by the trust. A wild swing in energy prices could dramatically change the value of your investment in a royalty trust as well as the dollar amount of distributions you receive. Commodity prices can be very volatile, so prepare for a wild ride if you choose to invest in a royalty trust.

  Utilities

  Utilities companies tend to be very stable and predictable businesses that generate strong cash flow. Because consumers will always need water, electricity, natural gas, propane, and home heating oil to provide for their basic needs, utilities companies tend to weather economic downturns particularly well. Utilities also operate as franchises that give them the exclusive right to supply electricity, water, or natural gas to a particular area, which means they don’t really have to worry about a competitive company coming in and eating their lunch. Utilities companies have huge infrastructure requirements and can use the same infrastructure for decades. It simply wouldn’t be cost effective for a
new company to come in and try to rebuild existing infrastructure from scratch.

  Utilities tend to be heavily regulated because of the monopoly positions they hold. State agencies establish standardized rates that utilities can charge for electric, water, and natural gas to prevent the abuse of monopoly power. These rates generally allow a utility to cover its normal operating expenses plus a fixed percentage of profits on top of those operating expenses. The profit margin that is permitted to utilities companies will vary from state, but target returns on equity of 10% to 12% are common. A utilities company’s profit will be determined primarily based on how much water, electricity, or natural gas they deliver to consumers. If the company is generating a higher profit margin than state regulators desire, the regulators can force a rate cut. Conversely, if costs come in much higher than expected, utilities businesses can ask state regulators for a rate hike to cover their increased costs.