Dividend red flags ⛳️ | #3

Risks of dividends and how to tackle them

Hey peeps!!! 👋

As promised I have been pushing more content. In the last post, I talked about my love for dividends ❤️ and how I am using a dividend growth strategy to retire early. That post might have given an impression that dividend growth investing is all we need to be financially secured and there isn’t any risk to it. So, I am writing this to talk about a few risks associated with dividend growth investing and how I avoid them.

Overview

1. 🪤 Dividend trap

2. 🧾 Tax inefficiency

3. 🫥 Dividend policies

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🪤 Dividend trap

So, for early investors the higher the dividend yield, the better it is sentiment is always there. A higher dividend yield is not always the best investment. Dividends make companies attractive and some companies use dividends as a facade to make stocks attractive to reach certain milestones. Always remember, there is a company behind the investment. If you are lured into an investment due to a higher dividend yield but with poor fundamentals, it’s a dividend trap.

Here are a few things I do to avoid dividend traps:

1. 🏦 Check their debt to equity ratio: The debt to equity ratio is total debt divided by shareholders’ equity. This is the ratio of your leverage or risk, generally, the higher the ratio, the riskier it is. If a company has incurred high leverage and instead of focusing on paying its debt, it can be a red flag. ⛳️

   I like my D/E to be around 1.0 to 2.0, however, some industries like real estate by nature need more leverage. So, I compare it to the industry/sector average.

2. 🍰 Check the payout ratio: The payout ratio is the percentage of earnings paid out to its shareholders. Dividends are paid from the profit of the companies. There is always an opportunity cost associated with dividends, the money paid out as dividends can always be reinvested in companies to grow. Also, sometimes, some companies incur debts to pay out the dividends.

   For me, a good payout ratio is between 25% to 55%. REITs are exceptions though, they are by law required to give at least 90% of their taxable earnings to their shareholders.

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🧾 Tax inefficiency

This has been the biggest argument against dividend growth investing. The companies pay taxes on their profits, the profit is then distributed to their shareholders as dividends, and shareholders are required to pay taxes on dividend income as well 😳. It looks like an infinite money glitch for the government, not for the shareholders.

Here is how I avoid tax inefficiency:

1. ✊🏽 HODL stocks: If an investor holds a common stock for, generally, 60 days, it is a qualified dividend. Qualified dividends are taxed as capital gains.

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🫥 Dividend policies

Nothing is certain but death and taxes, not even dividends. The decision to pay or not to pay the dividends is made by the board of the companies. The board can decide either not to pay or cut the dividend anytime. So, that can be an issue if you are planning to retire using dividends.

Here is how I avoid dividend policies issue:

1. 📜 Check dividend history: There is a list of companies based on the number of years they have been paying dividends to their shareholders and increasing the dividend called “Dividend Aristocrats”. The companies are strong companies as well. With the right valuation, they can be a great bunch to pick.

2. 🥧 Check fundamentals: Although dividends are sexy, I love my company strong. A strong company like $COST can expand, continue to pay dividends to its shareholders, and manage debt.

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   Takeaways from this post:

   1. Dividends are sexy until they are not

   2. Look for a strong company that pays dividends

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It takes time, and effort to write an article. Some love from you would be super encouraging. Feel free to leave a comment and smash that ❤️ button.