When a publicly traded company pays investors a portion of their profits, it’s called a dividend. It’s typically a way of rewarding them for investing in the company’s success.

Before investors decide which company to invest in, they look at the dividend yield rather than the dollar amount they receive.

The yield is simply a ratio of how much cash flow you receive for the amount invested in a stock. It can be calculated by taking the annual dividend, dividing it by the share price, and multiplying that number by 100.

Like most investors, dividend investors often think about how to capture the biggest payout.

However, a company paying a high yield isn’t always a positive sign.

For example, if a share is yielding a lot more than its peers, it’s usually because its price has fallen aggressively.

High yields might look attractive… But usually the higher the yield is, the harder it is to sustain. Dividend yields are inversely related to the share price – a low-priced stock can have a high yield and vice versa.

Buying the high yield implies a risky bet on the company’s recovery and a struggling business model. That’s not generally the kind of risk investors who want safe, bond-like returns are looking for.

So, what should be the optimal yield for dividend investors?

The number that crops up time and time again is 3.5%. That’s been the going rate for companies with long histories of paying and increasing their dividends. These companies are part of an elite group in the S&P 500 known as Dividend Aristocrats.

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Each company in this group has increased its dividend every year for at least the past 25 years. The 25-year-minimum demonstrates company stability. After all, these companies need to prove they can pay their dividend in good and bad market conditions.

Dividend Aristocrats will often go to extreme lengths to protect their reputation. For example, both Chevron and Exxon Mobil borrowed money during the pandemic so they could sustain their dividends.

Since each Dividend Aristocrat has a fantastic history of paying and increasing dividends, naturally people want to own them. It’s not a mistake that many of the biggest holdings of Warren Buffett’s Berkshire Hathaway are Dividend Aristocrats.

The best time to buy these stocks is following a pullback. That’s when the yield rises. Savvy investors will wait until the yield rises to around 3.5% before they wade in and buy the dip. That’s the number investors have concluded is fair value for a share that has a better record of paying dividends than some government bonds.

Just take a look at this chart of Kellogg’s…

(Click here to expand image)

Since 2008, every time the yield exceeded 3.5% it was a good time to buy. 

The reason I’m bringing this to your attention this week is because rising dividends is why stocks can perform well during inflation. Unlike bonds, stocks have adjustable returns because dividends can rise.

Companies can raise prices and sustain dividends. Bonds lose value during inflation.

The ProShares S&P 500 Dividend Aristocrats ETF (NOBL) currently yields 1.64% so it’s trading a little rich relative to where yield investors would normally buy.

The best time to buy is when the yield is higher and the price lower. To me, that suggests we are due some consolidation which will create the next attractive entry point.

All the best,

Eoin Treacy
Co-Editor, Market Minute

P.S. In yesterday’s Market Minute, I released my first video in our Eoin’s Insights series where I discuss my thoughts on current trends in the market. I’ll be putting out these short videos every Friday and hope you’ll tune in to watch.

If you missed the first one yesterday, just click here to see what I think about the recent fall in “stay-at-home” stocks, inflation, and the trades to watch for post-pandemic.