‘Dividend stock’ is a phrase widely used to refer to a popular subsection of equities. In this article, we’ll explain what a dividend stock is and how to trade them.
This article is written as a how-to guide and is not a recommendation to invest in dividend stocks, including the securities listed in this article. If you’re unsure about investing and want formal guidance from a professional, consider using the services of an independent financial adviser (IFA). An IFA will be able to take your circumstances into account and provide clear suggestions that you can act upon.
What are dividends?
A dividend is a distribution of company profits to shareholders as a cash payment. This can happen quarterly, bi-annually or annually.
Proposed dividends are announced in the published financial information that companies release to the stock market. A dividend paid mid-way through a year is called an ‘interim dividend’, and a dividend paid after the year-end to catch up the payment to the Board’s desired level for the financial year is known as a ‘final dividend’.
A company may only declare and distribute a dividend using the profits of the company, rather than its initial starting capital. This rule protects creditors by preventing a company from distributing its entire net assets as a dividend ahead of bankruptcy.
What is a dividend stock?
A dividend stock is a publicly-traded share which carries an attractive level of dividend.
There is no official definition of how high a dividend must be for a share to receive the label of ‘dividend stock’. It’s completely subjective.
Some investors may refer to any dividend-paying company as a dividend stock, while others may reserve the title for only those that offer a substantial yield, such as 3%+.
Why do investors prefer dividend stocks to growth stocks?
Some investors prefer dividend stocks because these investments have characteristics that match their personal financial needs. Retirees commonly hold dividend stocks using money that forms their pension. The dividend stream provides a (fairly) regular source of income that they can use to supplement any state pension provision.
Other investors prefer dividend stocks because they encourage the investor to focus on a steadily rising income rather than the total market value of shares (which can be very volatile in the short term). Holding dividend stocks can therefore feel less stressful than shares that don’t pay any dividend, and force their own to purely base their sense of success on the fluctuating value of their portfolio.
Both of these reasons are linked to convenience and psychology rather than investment merit. That’s because the total returns to shareholders are ultimately driven by the profit attributable to shareholders, not the portion of those profits that the Board decides to distribute to shareholders. Whether or not a company chooses to pay out its dividend or reinvest it within the company, investors should be theoretically indifferent so long as the investor can put the dividend to good use, and the Board can productively reinvest the cash.
How to trade dividend stocks
There are two distinct ways to trade dividend stocks and reap the long-term rewards of dividends:
- Buy underlying shares via a stockbroker
- Trade dividend stocks using contracts for difference
Buying dividend stocks with a stockbroker
Investors may use a traditional stockbroker to purchase dividend stocks in an investment account or stocks & shares ISA.
While you will own the underlying share, most brokers won’t send you a share certificate to evidence your ownership of the shares, because they actually hold them in trust, in the broker’s own name, on your behalf.
This complex setup will still provide you with the right to enjoy all the financial benefits of owning a share, but you will not be officially listed as a shareholder in the company’s own shareholder register. Instead, they will only see that your stockbroker holds the share.
A stockbroker will usually charge a flat fee to purchase (and later dispose of) a dividend stock. In addition, they will collect a 0.5% stamp duty on behalf of HMRC.
Trading dividend stocks using contracts for difference
Alternatively, you take a position in dividend stocks via contracts for difference (CFD) providers.
A CFD is a contract between you and the provider, so you don’t own the underlying share, however, you will receive a financial return that is directly linked to the performance of the shares, including the effect of receiving dividends.
Therefore, before fees, taking a long position in dividend stocks via a CFD provider can produce a very similar return to buying the underlying asset.
CFDs don’t attract stamp duty, therefore you will save 0.5% on the purchase price of the asset compared to using a stockbroker.
CFD trading is typically leveraged, meaning you can take a larger exposure than the cash you assign to the trade.
Please see our CFD articles series for an introduction to how CFDs work for more information.
Dividend v holding cost arbitrage
Trading with leverage creates the opportunity for a long-term CFD strategy for dividend stocks.
Leverage comes with a cost – this is usually charged daily (overnight) based on 1/365th of an annual financing cost. This financing cost is the expense of not using your own equity to back your trade.
However, some dividend stocks have yields that exceed the financing cost of holding the share. This means that, if the dividend yield holds up, the leveraged position would cover its own cost of finance. This would allow you as the equity holder to benefit from any difference between the two, and also experience any up or down movement in the price of the share.
For example, one broker could charge overnight holding costs on GBP shares based upon a 4.19% annual percentage. Simultaneously, there are seven companies offering a dividend yield that exceeds this percentage. Morningstar reported an expected yield of 6.32% for Vodafone PLC.
This means that a trader who uses the maximum leverage of 5x could use £1,000 to gain a £5,000 exposure to Vodafone. Using current expectations, this could generate a dividend income of £316. Less holding costs of £209 would leave £107 – equivalent to a 10.7% net dividend yield on equity.
This is only an illustration – dividend yields and holding costs may vary. This is not a recommendation but simply an explanation of a CFD trading strategy that can turbo-charge dividend yields in exchange for the increased risk of holding a leveraged position.
Dividend stocks are publicly traded shares that pay a cash return to investors. You can buy the underlying asset with a stockbroker, or take a leveraged position directly linked to the price & return of a dividend stock using CFDs.
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.
Tax treatment depends on your individual circumstances. Tax law can change or may differ in a jurisdiction other than the UK.
Please note that past performance is not a reliable indicator of future results.