Dividend Investing vs Value Investing: Which Strategy Can Build Your Long-Term Wealth?

Ever asked the dividend investing vs value investing question? Which is the right strategy for me?

Say you know for sure that you are philosophically a long term investor. Your primary goal is to create wealth for your future and pass it on to the next generation eventually. You are not interested in the hot new trends – you can see yourself as a disciplined investor, consistently and patiently tending to your portfolio, never wavering, and always knowing you are using the strategy that has proven to be a solid and reliable strategy in the past for countless many to generate substantial wealth.

What is this strategy that you are using?

It could be one of either Dividend Investing, or Value Investing. There are some key differences between the two – not only in the process itself, but also in the mindset you need to be a successful investor of either kind. In this article I will describe both the strategies, highlight the key differences, and give you enough information to decide for yourself which one you identify with. Dividend vs value investing choice is not mutually exclusive, you can use both strategies at the same time in different portfolios, or for different goals, or you can use a blend. Or you may decide to focus on one. It is your choice.

Let’s get to know the details now.

What is Dividend Investing?

When companies make profits, very often they share it with the shareholders like you and me. There are two ways of doing this – buy paying out a portion of the profits to the shareholders in form of a dividend, or by repurchasing the stock from the owning shareholders. The company can also choose to do neither – in which case they keep the earned profit in the business and reinvest for future growth. In this scenario, the shareholders may also benefit when the stock price rises.

Here we will talk about the situation when the company pays a portion of the profit to the shareholders in form of dividend. The dividend is paid out to each individual shareholder in the proportion of their shareholding. This is done by calculating dividend payout as a per share amount and then paying you that amount for each share you own.

In the United States, most companies pay dividends on a quarterly basis. There are a few companies that pay dividends on a monthly basis. Outside of the US, it is common to find companies that pay dividends once or twice a year. Occasionally, companies may issue special dividends that are not in the regular schedule. These are one-off payments that may be declared for many reasons, including windfall profits, significant asset sale, etc.

You may find dividend stocks appealing because you receive predictable income on a periodic basis. This income is yours to do as you please. If you reinvest this income in more shares of your stocks, you start compounding your dividends. If you are invested in solid and growing company, this compounding will lead to rapid growth in your shareholding and portfolio value.

Typically mature companies with good profit history pay dividends as they are no longer chasing growth. Therefore, dividend investing tends to be more reliable predictor of success, though as with anything in investing this is not a guarantee.

As a dividend investor, you need to know the difference between high yield stocks and dividend growth stocks.

High Yield Stocks: Some stocks pay very high dividend yields, often greater than 5% annually. Some of the most common situations you will find this are in the Real Estate Investment Trusts (REITs) and Business Development Companies (BDCs). These companies are legally required to payout over 90% of their income as dividends to maintain their tax status. In some other cases, the dividend yields may be artificially high as the company stock price may have cratered for some reason. This can be a red flag and a signal of distress. Often in such cases, the high dividend yield is temporary as the company is eventually forced to reduce or eliminate their dividend to conserve cash. So always question why, if the dividend yield is > 5%.

Dividend Growth Investing: This is the sweet spot of dividend investing. As a dividend growth investor, you look for companies that not only have a history of paying dividends consistently, but are also growing these dividends every year. Additionally, you want these companies to not over-stretched because you want them to be able to continue paying and growing these dividends in years to come. If you reinvest dividends, not only you are compounding because you own more shares every year, but you are also compounding because your shares pay you more in dividends per share every year. Doing this consistently can grow your portfolio at a significant clip. The question is how to find these companies. You can look for Dividend Aristocrats or Dividend Kings. These stocks have a long unbroken history of 25 years or more of paying a consistent and growing dividend.

Key Metrics to Watch for Dividend Investors

You have already come across the term Dividend Yield. Dividend yield is the ratio of dividend per share with the stock’s price per share. For example, if you buy a stock for $10/share, and the stock pays $1 per share dividend every year, the stock’s dividend yield is 1/10 = 10%. Please note that if the stock is a quarterly payer, it is likely paying $0.25/share every quarter in dividends.

Another metric to watch is the Payout Ratio. This is the percentage of its profit (or net income) the company pays out as dividends. We discussed how some companies are required to maintain a high payout ratio, often 90% or more. But suppose you come across a company which is not one of these regulated companies, but has a very high payout ratio (in excess of 60%), what do you do? Very often, a high payout ratio can mean that the net profit has declined significantly – in which case the dividend may or may not be sustainable based on what is going on with the business. And even if you determine that the company is healthy enough to continue the dividend, a high payout ratio means the company is close to the limit of how much it can payout as a dividend. Therefore, dividend growth potential is fairly limited.

Speaking of dividend growth, you should keep an eye on the Dividend Growth Rate. This is the rate at which the company has grown its dividend in the past. This could be shown as 1 year, 3 year or 5 year rate (or more, depending on where you are getting your data from). A sustained growth rate in dividends can indicate a robust growing business and management’s shareholder friendliness. This is a great signal and confidence booster for any dividend growth investor.

Why You Should Consider Dividend Investing?

You like receiving periodic and predictable income that you can use for any purpose you want, including reinvesting in your stocks. If you are risk averse, dividend investing makes a lot of sense. Having cash in hand is security. The companies you will invest in also tend to be old-reliable companies, so this also keeps the risk of loss down.

If you are retired, you may want an income generating portfolio. Dividend investing works very well for this. Even if you are not retired, you may use a dividend portfolio to supplement your income. For example, many business owners who have seasonal ups and downs will love the ability to have predictable income stream to depend on in the down periods.

Finally, dividend stocks can also grow in price because the company still reinvests a portion of their profit in new growth opportunities. Your total return from the stock is the price improvement of your shares + the dividends you received for holding these shares. Returns from dividends will likely form only a part of your investment returns.

What is Value Investing?

Value investing is the art of finding stocks that are selling at a discount to their fair market value, also called the intrinsic value. The idea is to find stocks that have been temporarily beaten down (for any number of reasons), and then wait for the market to correct its pricing. Once the price rises to the correct value, a value investor will sell the shares and book the profit.

Value investing has several key requirements from the investor:

1. Fundamental Analysis: A value investor needs to determine if a stock is undervalued. To do this, you will need to analyze the company business and its financials such as balance sheet and income statement. You also need to review the financial metrics or ratios to determine if the stock price reflects the correct intrinsic value of the company. You need to be comfortable reading financial statements and conducting industry and business analysis.
2. Margin of Safety: A value stock is often under distress, and very likely volatile. Once you buy the stock, you have no guarantee that the stock price will not continue to decline. As a value investor, you need to tolerate and indeed expect certain declines, but you can only do this if you are confident in your judgement of the stock’s value. What do you do to manage risk? You insist on a margin of safety. Margin of safety is essentially the degree of undervaluation. When the stock price is below the intrinsic value, the gap is your margin of safety. Benjamin Graham famously required a margin of safety of 30%. You can do more or less depending on your confidence in your valuation analysis and how much volatility you are able to tolerate.
3. Discipline and Patience: Once you buy the stock, you will need to patiently wait for the market to fill the valuation gap. This can happen within days or it might take years. Occasionally, you know there is a catalyst that can trigger this price appreciation. More often than not, there is no real catalyst and the market will do this with time. Again, discipline and patience only comes with a confidence in your skills in valuation and your investment thesis.

Why You Should Consider Value Investing?

If you are a long term investor who is willing to be patient and are comfortable analyzing businesses and stocks, you may want to consider value investing. Even though discipline is required and there is much uncertainty, the rewards can be significant.

Additionally, you need to have a contrarian mindset. What do I mean by this?

When you buy a beaten down stock that the whole market is written off, you are making a contrarian bet. You are going against the wisdom of the crowd. This is not easy, and if you have to stick to your convictions for months or years and there is no one else supporting your thesis, it can be very mentally exhausting.

The treasure of course is the high profits. With a few successes under your belt, you will get more comfortable taking contrarian positions.

Key Differences Between Dividend and Value Investing

Dividend and value investors are looking for different things. A dividend investor prioritizes regular income while a value investor is interested in capital gains. Please note that while a value investor may buy a dividend stock, dividends are not the primary goal. Similarly, a dividend investor may invest in an undervalued company and may realize capital appreciation, this was not the primary goal.

Dividend stocks are typically less volatile and more stable. Value stocks can be volatile, especially if they see significant news activity. Small company stocks tend to be represented disproportionately in the value stocks list, and small company stocks are generally volatile because their business is more volatile.

Dividend stocks do well in stable or low-interest rate environments. Value stocks do well during market turmoil, such as during economic recoveries. or market corrections since the company fundamentals and margin of safety means the stock is less affected when the economy is not well.

Dividend investing is generally easier to understand and do if you focus on a few selected metrics. Value investing requires deeper research and mental fortitude. You also run the risk of ending up with value traps – stocks that are clearly undervalued but they stay stuck at the undervalued levels for a long time.

How Do You Combine the Two Strategies?

Yes, you can be a dividend value investor!

You can combine the value investing and dividend investing strategies together. As I mentioned, value investors often end up buying dividend stocks and dividend investors often end up buying undervalued companies. This is not by design – but what if you alter your process to ensure that the stocks you choose are both undervalued and pay dividends?

If you are a value investor, you can just add a filter for dividend yield >0 in your stock screener. If you are a dividend investor, look for valuation metrics such as price to earnings or price to book ratios to be below the market average (or significantly below if your are more conservative). I use Stock Rover for my research (affiliate link) and these filters are easy to add.

Alternatively, you can leave it to the experts and look for ETFs that target both value and dividends.

Johnson and Johnson, JNJ and Pepsico, PEP are examples of two stocks that are both undervalued today and also pay consistent and growing dividends. DGRW and SCHD are examples of two ETFs that focus on growing dividends with reasonable valuation.

Which Strategy is Right for You?

Are you a value investor or a dividend investor? Or a little of both?

Before you answer this question, consider your risk tolerance and investment horizon. Do you need income now or are you willing to be patient for a while. Will you be able to stay the course if you don’t see the returns right away? If yes, then you may be a value investor. Do you need to see income on a regular basis? Then you should choose dividend investing.

Consider your age and stage of life. Value investing requires a long runway and if you are not sure you will be able to give it that, dividend investing may be more appropriate. Of course, older folks can still be a value investor if there goal is not retirement but building generational wealth.

As a dividend investor, consider reinvesting by enrolling in a DRIP (Dividend Reinvestment Plan). This will ensure that your portfolio compounds and grows as your dividends come in.

As a value investor, review your portfolio regularly to ensure that your stocks are not becoming value traps. Use the financial ratios such as P/E ratio or P/B ratio.

Whichever way you choose, I hope this article helps to guide you towards your investment goals.

Photo by Allison Saeng on Unsplash