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Is Income Investing for You?

Lou Carlozo

To what end should dividends drive an investor to invest? Truly, every dividend has its beginning, friends -- at least in terms of how to start buying the stocks that offer them.

Aside from the obvious "which stocks" question, there's no shame in studying the basics to get there. Answering these questions will help:

-- Does a healthy dividend equal a healthy stock?

-- How come not all stocks offer them?

-- What are those dividend do's and don'ts?

[See: 10 of the Best Dividend Stocks to Buy for 2019.]

In basic terms, a dividend is a payment companies extend to shareholders as a result of quarterly excess earnings. And they can fatten portfolios over time. Experts contend that dividends can open the door to reliable returns, with the goodies sometimes streaming in for generations. What's more, reinvested dividends over time can accumulate a large number of additional shares, which ignite the dividend's initial value if the shares appreciate.

But before you rush for the nearest dividend gusher, take note that the digits aren't always what they seem.

A high dividend yield may seem like a very good thing, but guess again. That number measures the dividend amount divided by the stock price and thus "consumers investing in dividend stocks for the first time should be wary of the highest yielding stocks, real estate investment trusts and master limited partnerships," says Daniel Kern, chief investment officer at TFC Financial Management in Boston. "High yields are often a signal of financial distress."

So where to begin? "First, you need to decide an investment strategy," says Marc Pfeffer, who serves as chief investment strategist for Omaha, Nebraska-based CLS Investments. "Why do you want stocks that pay dividends? Many growth companies do not. Some reinvest the profit to grow the value of their stocks while others will pay it out in the form of dividends."

And yet, otherwise robust dividends can disappear without a trace. How does one know a dividend isn't going away? Well, that can happen at any time.

Former dividend aristocrat General Electric Co. (ticker: GE) began to slash and burn its investor payouts in November 2017 -- from 24 cents to 12 cents -- and then repeatedly hacked away until they hit rock in December 2018: just a penny per share. That's same amount it cost GE co-founder Thomas Edison in 1881 to produce carbon filaments for his first light bulbs.

Then again, GE investors had plenty of warning their dividends were headed south. Dating back two years, the stock has fallen by two thirds and trades at just $10 per share today. Thus finding a safe dividend often boils down to examining a company's cash flow.

Kern explains how this works: "Comparison of dividend payouts to cash flow can identify how safe the payout is. Cash flow is harder to manipulate and often less variable than earnings, so many investors look at cash-flow metrics as the more important measure. The lower the ratio, the higher the margin of safety associated with the dividend."

[See: 6 Great Tips to Build an Income-Producing Portfolio.]

As noted earlier, companies that don't offer dividends -- examples include Amazon.com ( AMZN), Tesla ( TSLA) and Netflix ( NFLX) -- often decline because they're following a vigorous pro-growth agenda. Money that would otherwise go to shareholders gets plowed back into the business with investors then rewarded, at least in theory, by a rising share price. There is some wisdom to this, as Netflix has climbed 18% over the last 12 months; Amazon is up 23%. That beats any dividend, right?

Yet these are also the very stocks that investors can drive high above their true value, as in Tesla's case.

"Tesla is an uninvestable stock for me," says Vitaliy Katsenelson, chief investment officer and CEO at Investment Management Associates in Greenwood, Colorado, and author of "The Little Book of Sideways Markets."

Why the lack of Tesla love? "It's not just because of its high valuation but also because it fails our fairly basic quality test, which I shamelessly borrowed from Warren Buffett: Would I still buy this stock if right after the purchase the stock market were to close for 10 years?"

That doesn't mean he hates the car, though. Katsenelson offers this personal disclosure: "I'm an unsecured lender to Tesla through my $1,000 deposit on a Model 3."

At least one legendary economist contended dividends aren't worth anyone's time. Fischer Sheffey Black opened his controversial 1976 paper, "The Dividend Puzzle," by posing the question "Why do corporations pay dividends?"

[See: 10 of the Best Stocks to Buy for 2019.]

And yet, there's indeed another side to the puzzle. Dividends have a steadiness to them that share prices don't, especially when companies get hit by market headwinds. Dividends are often the hallmark of more mature companies, such as 3M Co. ( MMM), Dover Corp. ( DOV) and Genuine Parts Co. ( GPC) -- all of which have awarded rising dividends since Dwight Eisenhower was in the White House.

"Corporate finance theory suggests there is a signaling aspect to dividends; that is, the corporation's management provides a positive signal of the future of a firm through raising its dividend," says Robert Johnson, professor of finance at Creighton University's Heider College of Business.

Thus the first step on the dividend journey can lead to a very happy ending, if you work out just the right balance. As Pfeffer says: "It's a good idea to have a mix of growth stocks -- ones that don't pay dividends versus ones that do -- to counterbalance and diversify a portfolio."

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