Investing in dividend stocks?

Q: I HAVE been thinking where to invest my savings for my retirement. The yields on money market have been low for some time. I wanted to invest in equities for higher returns but I am afraid that I may lose my capital. Are there other ways for me to invest that will give me higher returns?—Krizzha Ligo by e-mail

A: If you are looking to invest in equities that pay regular income with good upside potential for capital appreciation, investing in dividend stocks is the way to go. The current market downtrend amidst falling inflation and low interest rates offers a lot of opportunities for dividend stock investing because when share prices fall, dividend yields rise.

Buying dividend stocks is similar to investing in real estate that pays monthly rental income or buying long-term bonds that pays quarterly interest income. The difference is that in dividend stocks, your returns are higher.

Dividend stocks are ideal for long-term investors. Traders who are out to make quick profit on high flying stocks easily get bored with dividend stocks. If you are planning to invest your savings for retirement, make sure that you include dividend stocks in your portfolio. Here are five reasons why you need to invest in dividend stocks:

Dividend stocks pay regular income regardless of the market price of the stock

Buying dividend paying stock when share price is down enables you to lock in high dividend yield even when the stock appreciates. For example, if you bought PLDT when it went down to P2,770, you would have locked in dividend yield of 5.6 percent per year assuming the company will pay the same amount of dividend every year. This yield will not change even if the stock has recovered to P2,846.

Dividends are taxed lower as compared to interest income

Dividend income is subject to final withholding tax of only 10 percent as compared to the 20 percent final tax on interest income from money market securities. If you have a dividend stock and a bond that pay the same gross rate of 5.6 percent, you would have net yield of 5 percent from the dividend stock while you get a lower net yield from the bond of 4.48 percent. The savings can be significant in peso terms when you consider the difference over the long term.

Dividend stocks allow you to grow your portfolio at compounded growth rate

It has been said that to build wealth is to invest your money in an option that pays interest and let it grow through the magic of compounding. But most money market securities just pay interest and do not allow the reinvestment of interest income to earn interest again.

Growing your money through compounding can be made possible with dividend stocks. You can reinvest the dividend income that you receive by buying the same stocks every year. If you bought PLDT at P2,770 that gives out after-tax yield of 5 percent and you held on to it for 10 years by reinvesting its dividend, the value of your investment would have already grown to P4,776. This is not to mention that the market value of the stock by that time would have grown so much also.

Dividend stocks serves as hedge against inflation

Let’s say PLDT’s earnings per share of P157 will grow by an average of 5 percent per year while inflation at 3 percent for 10 years. The projected earnings per year by the end of 10 years will be P344 per share. Applying historical P/E of PLDT at 18x, you would get projected share price of P6,192.

The market value of a stock tends to increase through time because of the effect of inflation on earnings, hence dividends.

Dividend stocks protect you from earnings manipulation

Creative accounting allows companies to report rise in earnings by increasing accounts receivables. It may look good at first but a closer look will reveal that there was no real value added because no actual cash was received. If this was manipulated, the stock will eventually suffer.

On the other hand, companies that pay cash dividends demonstrate the high quality of their earnings. The higher the cash component of the earnings, the higher the value added to investment. Companies, after all, cannot pay cash that they don’t have. They must actually earn and receive it before they can distribute.

Dividend stocks may offer superior returns compared to bonds and other money market securities. But this does not come without higher risks.

There are inherent risks that you need to consider when buying dividend stocks. There is the risk that the company may pay lower or nothing this year because they need the money for expansion. Another is the risk that share price may decline significantly due to disappointing earnings, which could hurt your capital.

As an investor, your challenge is to lower your risks by doing your homework carefully before you invest. Take time to research on the company you want to invest in. There are many stocks in the PSE that pay dividends but not all share the same commitment to shareholders.

There are companies that pay little dividend because they are growing. It doesn’t mean they are not good. It is just that they need to reinvest the money to grow. There are companies that are already stable and happy to share their income to their shareholders.

When you research, ask these questions. What is the earnings track record of the company? How reliable is the company in paying out dividends historically? How much of their earnings are paid out as dividends annually?

If you want to play defensive against falling market, invest in dividend stocks.

Henry Ong is registered financial planner of RFP Philippines. To learn more about value investing, attend FREE talk on July 22, 7 p.m. at PSE Center. For more details, inquire at [email protected] or text <name><email><AFA> at 0917-3464126.