This is a guest contribution from Dividend Appreciation. 

Ben Graham once said that investing was most intelligent when it was most businesslike. In other words, investing in stocks is basically investing in businesses. And nothing guarantees success in business like pragmatism.

The logical investor will understand that stocks are nothing more than small pieces of different businesses. The whole point of going into business is to earn a return. If, for example, you had $100 you could leave it at the bank to earn 2% interest or invest in a company that probably earns more.

But earnings are unpredictable and much of the money made over the course of the year is actually invested back into the business. For investors who want to see tangible returns on their money or need the cash to live on, earnings don’t matter as much as dividends.

Dividends are known to be a lot more stable and predictable than company earnings. Every year, the company’s management gets together to announce a set dividend. Over the course of the year the dividend is paid out in a fixed amount on a set schedule. A lot of companies pay a significant amount of annual earnings in this form. Some have dividend yields that are much higher than interest rates on savings accounts.

All these factors have made dividend investment strategies a lot more popular. Here’s a simple guide to everything you need to know about this traditional investment technique.

The Source

If you want to understand dividend investing you need to start with their source. Understanding the link between dividends and profits is essential for any income seeking investor.

Of the 505 stocks listed on the S&P 500, only 85 do not pay a dividend. Of the 420 that pay a dividend most yield less than the yield on a 10-year US treasury bond. This means less than half of all stocks on the general market pay a dividend worth investing for.

Dividends are subject to change. Companies can either cut the dividend or stop paying it altogether if things go wrong. For example, American Capital Agency Corp (AGNC), Potash (POT), Williams Cos (WMB) and the iShares US Preferred Stock ETF (PFF) all cut dividends in 2016 for a number of reasons ranging from miscalculated credit risks to a fall in commodity prices.

The moral of the story is that a headline-grabbing dividend yield isn’t everything you need to know about a stock before you invest. You need to dig deeper and see if the profits are sustainable, the cash flow is positive, and the debt is low, before you can take a call.

The Benefits

There are a number of benefits of dividend investing. Firstly, if the yield is high enough, you can create a portfolio that can sustain your lifestyle while your wealth grows. So you can live off the 3% to 5% dividend yield while the capital appreciates.

Dividends are also fairly stable and predictable. Big blue-chip companies have a track record of paying consistent and growing dividends over many decades. Companies listed on the Dividends Aristocrats Index are a good example of this. Companies can return cash to shareholders when they feel that there’s no use for it within the company. Basically, the dividend allows you to use the money earned to invest in the most profitable venture possible.

Another advantage of dividends is the cost and tax-efficiency. It’s a clever way to steadily return money to shareholders since dividends are taxed differently from capital gains. For mature companies there are few ways to reward shareholders besides a dividend.

Finally, the biggest advantage with dividend investing is the compounding effect. Over the past five decades nearly half of the overall return of the S&P 500 can be attributed to dividends that have been reinvested. Even a modest dividend yield can substantially boost the compounding growth effect on your wealth over time.

The Disadvantages

There’s a few disadvantages with dividend investing. Firstly, companies that pay a dividend are under no obligation to continue paying it. They can cut the dividend or stop paying it altogether after a few years. Sudden changes in the business environment or the management could have a serious impact on the yield you can expect from dividends.

Secondly, dividend-paying companies tend to be in industries with low growth. Think utilities and oil companies. The reason their dividends are so high is because the business doesn’t have much opportunity for investment within its industry. There is simply too much excess cash on the books and that cash is disbursed out to investors. While investors can expect a healthy return on their investment, they cannot expect the sort of phenomenal growth or capital appreciation that a new consumer tech or biotech company would have offered.

Take, for example, two of the biggest companies on the market – AT&T (T) & Google (GOOG). While Google pays no dividend at all, there’s no way you can compare its growth potential to that of AT&T.

Creating A Strategy

The only way to deal with the uncertainties and disadvantages of dividend investing is to have a strategy in place to keep you disciplined. Meticulous research and a little bit of insight will go a long way, but eventually investment performance boils down to your level of discipline.

Start by figuring out what your goals are. Estimate the yield you can expect and the yield you need to live on. Check an index that tracks dividend history, like the Dividend Aristocrats Index, to find some rare dividend-paying gems. Select the ones with the most growth potential and the most financial strength to sustain their dividend policy. Buy and hold a small basket of excellent dividend stocks for the long-term.

The Best Dividend Stocks

The best dividend stocks are usually the ones with the highest yields, a long history of consistency, and an ability to keep generating substantial free cash flows. Here’s a few examples:

ExtraSpace Storage (EXR): REITs are usually pretty high on dividend investment lists. The business model allows these companies to pay out tons of cash every year and this means REITs offer some of the highest yields on the market. But a lot of them are saddled with too much debt and operate in unpredictable markets. EXR, meanwhile, has a unique business model that is nearly recession-proof. It rents out storage space across the country. The dividend yield is currently 3.7% and funds from operations (FFO) is growing at a reasonable pace. The payout ratio is close to 70% while the company has managed to increase dividends by 457% in the past five years.

Apple (AAPL): Apple would have never paid a dividend during the Steve Jobs era, but the company has changed since his demise and is now one of the most valuable dividend paying stocks on the market. The stock trades at 13x earnings and yields close to 2% in dividends. The company has way too much cash on the book and it seems likely the dividends will keep growing at 10% annually. That means dividends can double every 7 years or so.The company’s buyback program also adds a lot of value. Let’s not forget that Apple is still a market-leader in the smartphone and tablet space. One more great product and the stock price could keep heading north for the foreseeable future.

AT&T: Telecoms sector is a great place to start your hunt for yields. AT&T currently yields an astounding 4.5% and has more than enough cash to support that dividend for years to come.

Remember, dividend investing is relatively straightforward and incredibly effective. While picking stocks to add to a portfolio you need to pay attention not just to the dividend yield but also the sustainability of the dividend.