In bear markets there are great buying opportunities for dividend growth stocks that are offering yields above their historical averages.  Opportunities to buy great dividend growth stocks at above average yields is a great way to finance your retirement and increase the compounding effect of your future income from these stocks.

Here are the 3 most essential reasons that I prefer dividend investing: 

1.) Dividends offer investors fantastic flexibility.

Dividends give you tremendous financial flexibility throughout your investing life. While you’ve got an income from working, you can reinvest those payments to speed the process of compounding your wealth. Once you’ve decided to retire, the cash thrown off by dividends spends just as well as any other source of money!

What is even better, a rising dividend payment can help you fight inflation by providing you more cash every single year.

2.) You can’t fake money in your pocket. 

Dividends also have the added bonus of being exceptionally difficult for companies to fake. After all, it’s difficult to convince lenders to loan money to a company if that company is going to turn around and hand it over to its shareholders.

As a result, to sustainably make and increase those dividends, the business needs to generate serious cash on both a regular and repeatable basis.

3.) Dividends are paid from the company’s cash flow. 

Perhaps most important, a company’s dividend payment comes from its operational success and not from the panic, hype, or analyst interpretations that influence its stock price. Throughout these rocky market periods, dividend payments allow us to make money even when the stock price moves lower.

Why Invest In Dividend Paying Stocks?

• Quicker compounding.
• Increased financial flexibility.
• Cash in your pocket without selling.
• A hedge against inflation.
• An check on the company’s accounting.
• Cash Flow in a down market.

With all of the benefits of dividends, it’s obvious why they can be an integral component of one’s portfolio.

Did I miss any benefits of dividends?  If so, let me know in the comments! 

A Variable Dividend

Progressive introduced the idea of a once-per-year variable dividend that will be based solely on the performance of the company.  This type of dividend will award shareholders for their belief in the company and appears to actually treat shareholders like owners by offering up a piece of the profits in good years and leaving them high and dry in bad years.

Here is what Progressive CEO Glenn Renwick has to say about the dividend policy that he championed:

“If the business has a good year, the owners should share in the profit, and if the business has a bad year, why should the owners get anything?”

An excellent observation–one that’s so obvious, it makes one wonder why everyone’s not thinking that way.

My contention is that investors, including myself, are fickle.  As investors we really have no control over the operations of the company and when our cash flow (dividend) is not paid, the only recourse that a dividend investor has is to sell the stock.

Conversely, when there is a big dividend to be had, I would want as many shares as possible.  One may think that this will lead to erratic cycles in the stock price of Progressive as “yield hunters” trade the stock over the course of time.

How The Variable Dividend Works?

Progressive’s board has opted to pay a variable dividend based on the firm’s after-tax underwriting profit. That means the premiums Progressive takes in, less claims paid out and expenses of running the business. Shareholders will get 40 percent of those profits in a great year, 20 percent in an average year, zero in a bad year.

So, what consitutes a Great Year, Average Year, and Bad Year?

It’s not entirely carved in stone , but It helps, of course, that Progressive is solidly profitable and generates far more capital from its operations than it can profitably deploy in its business. But should things turn bad, which has happened to many once fine companies, Progressive won’t be stuck trying to defend an unaffordable cash dividend that shareholders have come to expect. In these volatile days, locking yourself into a significant fixed dividend can be a bad idea.

Could This Dividend Policy Work For Other Companies?

If other companies could stomach what seems to be the inevitable swings in stock price, then this policy may work for them because they would pay out what dividend they could afford and no more.

While this would produce stronger companies in that sense, investors who are seeking regular income (who, as our population ages are more and more), may steer clear from companies offering an unpredictable payout.  This lack of investor confidence could ultimately result in a lack of capitalization that would ultimately harm the operations of the organization.

Because the strength of a company and the performance of management is ultimately gaged on the price of the company’s stock, this dividend policy seems risky for those managers, investors and companies that are more conservative.

I guess we will have to wait a couple of years to see how this policy plays out for Progressive.  While it seems very good in theory, it certainly bucks the trend of traditional dividend theory.

First, let’s talk about why we like stock buybacks.

Advantages to the Investor

1. Buying back stock means that the company earnings are now split among fewer shares, meaning higher earnings per share (EPS). Theoretically, higher earnings per share should command a higher stock price which is great!
2. Buying back stock uses up excess cash. The returns on excess cash in money market accounts can drag down overall company performance. Cash rich companies are also very attractive takeover targets. Buying back stock allows the company to earn a better return on excess cash and keep itself from becoming a takeover target.
3. Buying back stock allows a company to pass on extra cash to shareholders without raising the dividend. If the cash is temporary in nature it may prove more beneficial to pass on value to shareholders through buybacks rather than raising the dividend.
4. Buying back stock can increase the return on equity (ROE). This effect is greater the more undervalued the shares are when they are repurchased. If shares are undervalued, this may be the most profitable course of action for the company.
5. When a company purchases its own stock it is essentially telling the market that they think that the company’s stock is undervalued. This can have a psychological effect on the market.
6. Stock buybacks also raise the demand for the stock on the open market. This point is rather self explanatory as the company is competing against other investors to purchase shares of its own stock.

What Management Doesn’t Want You To Know!

There are several reasons why management would prefer to buy back stock rather than raise the dividend.

The first reason is that upper management typically will receive compensation that is tied to the company stock price. What this means is that they typically make more money when the stock price goes up. This compensation may come in the form of stock options, rights or other forms.

In the short term management believes that dividends may work against the stock price of a company by reducing the book value of the stock. In addition, if managers have stock options, they do not immediately benefit from dividends as their options do not qualify for dividend payments.

On the other hand, when a stock buyback occurs the short term implications on the stock price are typically positive (due to the previous listed reasons). And, since this allows management to see the most immediate results to their compensation, it is no wonder that managers prefer stock buybacks as opposed to dividend increases.

What to Watch For

As an average investor, it is beneficial to us to look for companies that have both the cash-flow to buy back shares as well as regularly increase their dividends. One specific thing to look for is the dividend payout ratio.  Companies that have a lower dividend payout ratio, say below 60% of earnings, will have more money to invest back into the company and grow the stock price.  These can be some of the best long term investments because the company finds multiple ways to increase shareholder value.

We have also heard all of the “talking heads” on television talk about diversification.  They are more than likely talking about diversifying within the stock market.  Diversifying between stocks, sectors, and industries as well as between fixed income investments like bonds and equity investments like stocks.  This is usually good advice, but what about other types of investments?  Where do they fit in the picture and how can they help you to further grow and protect your wealth?

What Happens Next?

At Blueprint for Financial Prosperity, they ask what is next in your financial plan after you have successfully accomplished the following:

• Paid down all your debt until all you owe on is your mortgage.
• Maintain six months of expenses for your emergency fund in a high yield money market account.
• Fully fund your and/or your spouses 401k, 403b, 457, etc.
• Maximize your and/or your spouses Roth or Traditional IRA up to the allowable limit.
• Invest some money each month in a 529 plan (and possibly even a Coverdell “Education” IRA) for each of your children’s future educations.
• Set aside some additional money each month and at bonus time into a taxable brokerage account for such goals as that long-awaited trip to the Orient, the sunny vacation property on the water, or even retirement.
• All your investments are properly diversified by asset type according to your goals, time frame, and risk level.

The article goes on to mention investments in tangible assets such as gold coins or a stash of gasoline, although the latter is difficult to manage.

Diversify Away From The Stock Market!

I would suggest that diversification away from the stock market take into account a variety of tangible assets such as precious metals, raw land (vacation property is preferred), Real Estate, and valuable collectibles or antiques.

You should be aware that these tangible assets typically have narrow markets and can be very illiquid. However, they can be very valuable in times when the stock markets are out of favor and should comprise a small piece of one’s overall investment portfolio.

It is essential that you do your due diligence with every form of investment. Purchasing these tangible assets can be tricky if you are not well versed in the particular niche market. That said, thorough research could yield tremendous value so get out there and test the waters!

I have little in the way of antiques and coins, but I have had some success with Real Estate and I do own some semi-valuable sporting collectibles.

I am a strong believer in diversifying away from the stock market and I prefer rental Real Estate because I am adamant that cash flow is the engine that drives wealth.  Real Estate is the only avenue where the average person can utilize the power of a mortgage as financial leverage to compound their wealth.

What Is An Opportunity Fund?

An opportunity fund is simply a stash of money that I set aside for investment opportunities that are almost certain to be profitable, but come about unexpectedly. They also usually require that the cash be accessible in a short period of time.

Jim outlines the opportunity fund as akin to the emergency fund, which I have talked about as well. Many folks like to keep their emergency fund and “opportunity money” separate. This is probably the ideal situation for most. However, over the past several months, I have been raising cash awaiting investment opportunities. I have also sold a condo in March for a nice profit and needed to store the cash until another opportunity came along.

Instead of opening an additional account for this opportunity money, I simply added it to my ING Orange Savings Account where it earns higher interest as part of my emergency fund.

How Much Opportunity Money Should I Have?

That depends.

The amount of money in your opportunity fund should not be a significant portion of your net worth and it certainly shouldn’t be more than your emergency fund! My rule of thumb is that I like to have about 1-2 months of net salary in an accessible account for opportune investments.

For instance; after I sold a condo in March I kept the profits available and liquid while searching for another opportunity.

Normally, I would have invested the majority of those funds in dividend paying stocks. However, I didn’t like the way the market was performing at the time and I am overly invested in the stock market as a whole.

Why Not Use A Line Of Credit

While I do have a large line of credit on my home that I use for quick purchases of undervalued real estate, I don’t advocate that the average person do so. My home equity line of credit is used in the same fashion that my opportunity money is, but it takes on a lot of risk. I only use this type of financial leverage when I have done some serious homework and the asset is very undervalued.

My most recent purchase as an example:

I just purchased a 2BR condo in a growing community for $89,000. Comparable units have recently sold for between $104,000 and $124,000. As you can see the asset is at least 15% undervalued.
(More on this in a future article)

Using financial leverage like a line of credit or mortgage can be an excellent tool to building wealth, but it can also make you poor in a hurry if things go wrong. I have written an excellent example on this subject in the past and I strongly suggest that you read it if you have not already.

Here is the link to the article:

http://dividendmoney.com/understanding-mortgages/

For Assets Only

Opportunity fund money and money borrowed (credit) should only be used to purchase assets. That is, if the object purchased does not appreciate in value or put cash flow in your pocket, then it should not be purchased using a line of credit or opportunity money.

This is where the average person is steered wrong by the pressures of consumerism in our society. Many folks see money in their account as “extra” money that can be spent on anything. It is up to use to develop our own financial will power to make sure that we are investing our “extra” money for a more prosperous future.

How do you fund opportunity investments?