Investing in dividends: Basics, advantages and disadvantages

Investing in Dividends: Fundamentals, Pros and ConsInvesting in dividends or “dividend investing” is one of the branches with the most followers within value investing. Like all of them, it has its advantages and disadvantages. In this article I will discuss the fundamentals of dividend-based investing, as well as its main advantages and disadvantages.

The dividend-based investing style

The dividend-based investment style is based on 2 pillars:

  • The dividend yield, which is the percentage that companies pay in relation to their listed price. If a company trades at € 100 per share and pays out € 5 per share per year, it has a dividend yield of 5%. Simple truth?
  • The stability and sustainability of dividends is also an essential factor. It is useless for a company to have a very high dividend yield this year if it can end up bankrupt in a couple of years. Therefore, a deep competitive analysis is necessary to help us determine the strength of the company in the market and its ability to maintain dividends or even increase them in the future.

Advantages of investing in dividends

One of the main advantages of investing on a dividend basis is its simplicity, which helps you focus on companies that pay a high dividend and leave out the rest.

In addition, this method offers a conservative selection criteria that filters out companies with less mature and established businesses. Therefore, it is a way to mitigate the risk of investing in businesses that in the end have not quite flourished.

Also, companies that offer a high dividend yield tend to have less volatility than companies that do not. Therefore, it is a method that can be interesting for investors who do not bear well the ups and downs in prices.

Disadvantages of dividend investing

The first drawback of this strategy is the loss of investment opportunities. It is true that this method rules out many companies that are not worth it, but it also greatly limits our investment opportunities.

However, the biggest drawback of investing based on dividends is taxation. A company that trades at € 100 per share and distributes € 5 per share per year, has a dividend yield of 5%. However, this is not its real profitability, since we have to subtract the percentage that is left behind. Currently, this year's taxation was between 20% and 24%. Therefore, a dividend yield of 5% was converted to a real yield of between 3,95% and 3,65%.

The fiscal problems of this investment strategy have been aggravated this last year by the measure taken by the government to eliminate the tax exemption for the first € 1.500 received in dividends each year, which is possibly one of the most regressive tax measures against small investors in recent decades.

There is an exception to this fiscal problem, which is large fortunes. If you have a large wealth and can afford your own SICAV, then you can defer your taxation without problem. If you are a small saver like I am or as we are surely more than 99% of the readers of this blog, we will have to bother and pay every time we receive the dividends that correspond to us.

My take on investing based on dividends

In my opinion, investing solely on the basis of dividends is not an optimal investment strategy today. Despite its advantages, the tax penalty suffered by small investors is a difficult obstacle to overcome for dividend investing.

Personally, I invest in both companies that pay out dividends and those that don't. I believe that the dividend yield should be a criterion that is included in the business valuation process. Of course, I see with good eyes that companies do not pay dividends if they use that capital efficiently in a way that increases the value of the company in the long term, as is the case with Google or, until recently, with Apple or Microsoft.

Therefore, as long as we continue to have a tax system in which deferred taxation is only in the hands of the rich, this strategy will have a significant flaw in our country. If the project of the so-called SICAVs of the middle classes finally comes to the fore, I believe that this style of investment within value investing would become a good alternative for the more conservative investors.

Dividend Investing Blogs

Finally, I would like to recommend a few blogs that follow the dividend investment method. Although it may not seem like the optimal method today, it should not be lost sight of in case the legislation changes in the future.

Finally, I would like to thank Javier, a Spaniard who has emigrated to Chile, for the idea for this article.

I would also like to encourage you to leave your contributions, criticism and praise in the comments. As always, they will be received with open arms. 😉