Image Source: Pixabay

Dividend strategies are seen as one of the classic investment strategies especially, but not only, for income-oriented investors. Therefore, it is worthwhile to shed some light on the most common strategies.

As companies mature, they often start to use parts of their revenue to pay dividends to their shareholders since they may not need that capital to finance future growth. There are mainly two ways to distribute dividends to the shareholder. The first way is share buybacks, where the company buys back its own shares, resulting in higher earnings-per-share (EPS) as the number of shares outstanding is shrinking. The second way is cash dividends, which are cash payments from the company to the investor. Some companies split their dividends into share buybacks and cash dividends.

That said, investors often use the dividend yield as one of the main measures when selecting their stock portfolio. It is not surprising, therefore, that dividend strategies are offered as actively managed funds or as passive products (ETFs and mutual funds) either tracking dividend-based indices or building a portfolio (index) based on dividends as factor (factor-based approach). Regarding passive products, it is noteworthy that there are various approaches available that may take additional criteria into account to complement the dividend yield.

While value investors look at share buybacks and cash dividends, most investors who are implementing a dividend strategy are looking for a regular stream of income. Therefore, share buybacks only play a minor role for most dividend strategies offered as mutual funds or ETFs.

In more detail, some dividend strategies are based on the current dividend yield when selecting the respective constituents for their portfolio, while others look at the dividend growth and/or the expected dividend for next period(s). Obviously these two approaches can be mixed and there are other measures around the quality of the dividends, such as the stability of the dividend payments or the dividend payout ratio, which can be considered when selecting the portfolio constituents. While the stability of the dividend payments measures the ability of the company to pay out a (at least) stable dividend over a longer time period, the payout ratio measures the percentage of revenues that is distributed to the shareholders. A stable or increasing dividend yield is seen as a sign of financial health of a company. With regard to this, it is noteworthy that some companies hold some of their earnings in good years back to be able to pay out a stable dividend in years with lower earnings. As a result, the payout ratio can be above 100% in such years.

Even as dividend strategies are often considered as defensive equity strategies, chasing high dividend yields can add significant risks to a portfolio. This is especially true if an investor looks at the dividend yield only since the dividend yield is impacted by the share price, and in some cases the dividend yield might be high because share price has gone down significantly. This means that investors have to do their homework with regard to the due diligence on the respective company to minimize the pitfalls associated with dividend strategies. That said, even the best due diligence process is not able to protect investors from general market downturns or unexpected major corporate events.

Even as dividend strategies seem to be the right strategies for income-oriented investors, these strategies do not come without some risks. With regard to this, it is important that the investor understands which opportunities and risks are related to a given dividend strategy.

More By This Author: