Are Top Dividend-paying Stocks Really That Safe?

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There is little wonder why investors choose high yield dividend stocks during volatile markets. When share prices are slicing up and down faster than the tip of Indiana Joneses’ whip, people want to feel a measure of financial security. Do income paying blue chip stocks really provide that surety?

What Dividends Really Are

When a company earns profit they can either re-invest the money to expand or pay out a dividend to shareholders. If the profit is retained by the company, the share price should go up to reflect this. If the business decides to give profits back to the shareholder in the form of a dividend the share price drops by this amount to reflect equity being removed.

Either way, the shareholder should theoretically benefit from profits earned.

  • Profits retained help push up share price
  • Profits paid out to shareholders lower share price by amount of dividend.

You should either have more worth with increased share value, a cash dividend or a combination of the two. But all things are not equal. Why?

Warren Buffett and Blue Chip Dividends

In the book Buffettology, Mary Buffett explains why the Oracle of Omaha — Warren Buffett — often prefers stocks that do not pay dividends. Why?

  1. Retained earnings allow for company to reinvest in future growth
  2. Money is not taxed twice.

If a blue chip company has the ability to earn 15% profit on retained earnings, why would they choose to pay it out in the form of a dividend? As an investor, why would we prefer the cash payment when the company can keep the money and continue to earn 15% returns with the equity? And where will we put the money once we get it? Will our new investment pay over 15% per year? If the company keeps the earnings to grow, this will also have a compounding effect over time.

The second issue has to do with tax. The company has already paid tax on their earnings. When they pay out a dividend in most countries, the investor is taxed again. Some countries such as Australia have a fairer system using franking credits so investors don’t pay double tax. In United States and Canada, if a company chooses to re-invest the profit back into the company, the funds will only be taxed once.

Dividend Theory vs. Reality

Allowing a blue chip company to retain earnings for future growth will theoretically allow for a larger long term profit. But what is the reality of such ideals?

The market is not smooth. Instead, prices soar and slam downwards in a very erratic manner. Sometimes you will discover stocks that are trading below their book value, or net asset worth. In bull markets the same stock could be trading many multiple times that figure. Today’s investors are finicky. Strong fundamental stocks with solid plans may still get whipped around like a bird in a hurricane as attention-deficient traders ignore the valuations of a company.

Some investors who chose value stocks might find over time that the share price has barely appreciated despite smart management and the compounding effect of re-invested earnings. These investors knew that if dividends were paid out, this theoretically should have hurt share prices and future growth potential. Reality is: in bear markets almost all stocks get pounded hard. Good sense is thrown out the window when panic strikes.

The above investor may be tempted to buy dividend-paying stocks so that when the share price is trounced by a volatile market, he will at least have some dividends in his account. Sound arguments can be made for and against the best dividend-paying stocks found in blue chips.

High Yielding Dividend Strategies

If an investor chooses to purchase blue chip dividend-paying stocks, what technique can he use to maximize his income?

One very simple method is to buy the stock and sell long term options. More of this dividend stock secret can be found here. The net effect will be:

  • More shares at a lower price for higher net dividend yield
  • A hedging buffer against falling prices
  • Additional income earned from time value on options.

It is possible to buy a dividend stock and receive 40 -50% more dividend than investors who merely buy the stock. You might also be able to weather a price fall of up to 30% without any capital loss. Finally, you can possibly earn an additional 7-10% per year from the options’ value.

Top paying dividend stocks are not for everyone. But in today’s crazy market, many investors are closely looking at the strategy of regularly taking small profits from blue chip companies in anticipation of when another crash will occur.