When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.
Sometimes people wonder how much they’d need in a portfolio to generate enough passive income to live on. Even though this is an honourable goal, I think it’s often better to flip it around and look at a realistic portfolio size to see how much income it could generate. Based on an investor having built up a £50,000 portfolio over several years, here are my findings.
Setting the tolerance
Risk appetite is a big part of the equation that an investor needs to address. From the beginning of building a portfolio, an investor can choose a low-risk strategy or a higher-risk one. This is reflected in the average dividend yield of the portfolio. As a general rule, the higher the yield of a stock, the higher the associated risk.
The best way to think of it is to consider a stock with a rapidly falling share price. The drop would act to bump up the yield in the short term, potentially to very high levels. Yet, if the business is in trouble, the dividend might get cut. This means the yield wasn’t sustainable at such a high point.
A low-risk approach could be to buy an index tracker that provides the income from all the constituents. However, there’s a middle ground whereby an investor with moderate risk can achieve a higher yield than the index average. Part of this relates to holding a diversified portfolio including many stocks. Then, even if one company hits trouble and cuts the dividend, the overall portfolio isn’t that impacted.
A potential inclusion
One stock that I think worth considering for such a portfolio is the Supermarket Income REIT (LSE:SUPR). The stock is up 8% in the last year, with an attractive dividend yield of 7.7%. The fact that the share price isn’t falling rapidly gives me confidence that the yield isn’t being inflated by this factor.
The REIT makes money by investing in UK supermarket properties and earning rental income from long-term leases with major grocery retailers such as Tesco and Sainsbury’s. It’s an appealing business model, because the contracts are usually set for a decade or more, with rents increasing in line with inflation.
Given the conditions set in order to qualify as a REIT, the trust has to distribute the majority of rental earnings as dividends to shareholders. Although it’s not guaranteed, this increases the likelihood of future dividends.
Some flag up the REITs’ risk of being tied to a small number of larger clients. It’s true that if one of the major supermarkets ended the contract, it would be a significant hit to the company. Yet I see this risk as quite small.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice.
Monetary expectations
If the £50,000 portfolio was built using a middle-risk approach, I believe it could be currently achieving an average yield of 6.5%. This would equate to £3,250 a year. If it were higher risk, I think the yield could be tweaked to 8.5%, paying £4,250 a year. For a low-risk option, the index average of 3.3% would be realistic, offering potential income of £1,640 annually.
The mathematics of capital dividends is simple but surprising.
Alan Ray
Updated 24 Jul 2025
Disclaimer
This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.
One thing I’ve noticed in my parallel life as a mature university student is that sometimes experts struggle to explain concepts because they are so expert in a topic that it’s become second nature. To them, the idea that something needs explaining is akin to having to explain why it’s important to keep breathing. Luckily for me, and annoyingly for my professors, a few years in the City have given me high levels of confidence to ask stupid questions, so we normally get there in the end.
I found myself in a situation recently where the conversation took a turn against the concept of paying capital dividends, with a range of opinions but a consensus that they were a BAD THING. Showing an unusual degree of restraint, I just nodded and moved things along to the next subject, but I did think that’s interesting, I didn’t know people still felt that way. This was probably the right thing to do because in my mind capital dividends are a bit like breathing. Why wouldn’t you pay a capital dividend ? I needed a few hours to get my argument straight, so here goes.
Before we get into things, let’s clear one thing up. It’s a totally valid and successful strategy to invest in companies that pay ‘real’ dividends. The most obvious reason to do so is to collect and spend them, but it may also be because a company’s ability to pay, sustain and grow its dividend says something about its underlying business. There will be many investors happy with the income and growing dividends they receive from UK equity income trusts, exemplified by City of London(CTY) and its extraordinary run of dividend increases (59 years and counting…). And I daresay that many who chose to invest in UK equity income trusts reinvest their dividends. They just like the kinds of companies those trusts invest in. Or let’s think about the £2bn Fidelity European (FEV), not especially high yielding, but the managers place a great deal of emphasis on dividend growth in their stock selection. FEV has a tremendous record of dividend growth and its low-ish yield is a result of its very strong capital growth, which is the ultimate nice problem to have as an income investor.
Capital dividends allow investors to access different strategies which favour other types of companies, and so one might expect performance to have different characteristics. It’s sometimes said that companies that pay steady and growing dividends are mature businesses that have past their best growth years and are happy just continuing on the same path. Investors who bought Microsoft when it started paying a dividend might have cause to disagree with that, but nevertheless, on average that characteristic is rooted in truth, and may well be exactly what an investor likes. Strategies investing in companies with no yield can provide access to businesses at a different stage in their lifecycle, where retaining earnings for investment might result in higher returns. Or, it might just be that in a particular market the culture is different and dividends are seen as less important, and share buy-backs are favoured.
Warning: some mathematics
I’ll preface this by saying that I’m sure that there are those who don’t like capital dividends and who perfectly well understand the following mathematics. For all the financial modelling and big-data AI analysis the industry uses these days, instinct matters in investing, and if that’s a reader’s instinct, I say go with it. But on the chance that a reader hasn’t yet considered the numbers, let’s first walk through a simple example and then some different scenarios.
Let’s take an investment trust with a net asset value of 100p per share, a share price of 90p and thus trading at a discount of 10%. The trust pays a dividend of 4% of net asset value and, to keep things simple, it does it all in one go. In the real world this would most likely be quarterly, but the outcome will be similar.
Now, let’s take an investor who has invested £1,000 at that 90p share price and thus has 1,111 shares and some change left over.
The dividend the trust will pay is [4% x NAV] or [4% * 100p] = 4p per share.
The investor receives a dividend of [£0.04 * 1,111] = £44.44.
Now comes the clever bit. Clearly, one option is to spend the dividend. Perhaps grumbling about how you never wanted a capital dividend in the first place, but still, money is money, right? But what happens if you reinvest it?
Taking the £44.44, the investor buys some more shares at 90p per share. Ignoring stamp duty only for this example, that buys 49 more shares leaving a tiny bit of change.
So, the investor now owns 1,160 shares. The next day the investor is shocked to see that the NAV of the trust has fallen from 100p to 96p. Because the dividend is entirely paid from capital, the NAV is now [100p –4p) = 96p. And, maintaining the discount at 10%, the share price is now 86.4p. This can’t be good, surely?
Before the dividend was paid, the shareholder owned 1,111 shares at 90p = £999.90
After the dividend reinvestment the shareholder owns 1,160 shares at 86.4p = £1,002.24
Let’s go one step further and think about the underlying NAV the investor owns.
Before the dividend was paid, 1,111 shares had an NAV of 100p, so the investor owns £1,111.00 of NAV.
After the dividend was reinvested, 1,160 have an NAV of 96p, so the investor owns £1,113.60.
This last bit is important because NAV is, perhaps obviously, the engine of growth. The investor who reinvests their dividend is getting a slightly bigger engine without putting any more money to work. I won’t torture readers with another maths lesson, but conceptually, the value accretion of an investment trust buying its own shares back is very similar. Think of it like this, the investor has been handed a little piece of the NAV and used it to buy shares at the lower share price.
What does this mean for long-term returns?
Let’s take that maths and put it into an excel spreadsheet and expand it across ten years. Don’t worry though, we’ll just be looking at the chart that results and not diving too far into hypothetical numbers. Scenario A takes that same investor and then sees what happens if they continue to reinvest dividends over ten years. This time, to be pedantic, we have charged them stamp duty each time they reinvest. Maybe in ten years the nonsense of stamp duty on share purchases in the UK will be no more, but that’s another story. Each year, the investment trust’s NAV grows by 10%.
This is pitted against an identical investment trust, except that it does not pay any dividends. The investor simply buys, holds, and gets the same NAV growth rate and the same discount, 10%, persists throughout the ten years.
The chart below shows the value of the two investments. This is the actual value at the share price. That slightly bigger engine we discussed above has, over ten years, opened a slight gap. It is slight but it’s a gap.
Scenario A
Scenario B is identical except that the annual growth rate is negative 10%. Again, the reinvestment strategy works in the investor’s favour, with a slightly higher value, although obviously it can’t protect from a 10% annualised fall in NAV.
scenario B
Both scenarios show that reinvesting capital dividends can, incrementally, increase the value of the investment. The differences are small though, and one might therefore simply conclude that there really isn’t anything to fear from them. We discuss it further on, but the mathematics unravels when a trust trades at a premium, but the unravelling is so slight it’s probably not worth worrying about.
What about selling some shares instead?
There have been many attempts over the years to persuade investors that, rather than seeking dividends, they should consider selling a few shares every year. We know at Kepler that if we put ‘income’ in the title of an event, it will usually be well-attended and so it’s probably fair to say that that technique isn’t widely practised. Space prevents us from running through all the arguments for and against, but broadly it’s the same as for capital dividends: you can own companies that are more focused on growth and might end up better off that way. But since we’ve built a little spreadsheet, we may as well run another scenario, where we take those same two identical investment trusts and look at the returns if one takes an income from them either through capital dividends or by selling shares. Again, the Scenario C chart below shows the value of the investment over a decade, and again, the capital dividend gives a better outcome. In this case, an identical amount of income has been taken and spent elsewhere for both trusts, and the chart is plotting the remaining value of the shares.
With more on discounts and premiums below, for this specific scenario, we’ll just say that it will be better to sell shares on a premium to raise income rather than receive a capital dividend. But if a discount persists, the difference is actually a little more compelling than in the first two scenarios.
scenario C
What about discounts? And premiums?
There’s a danger once you’ve built a spreadsheet to prove a simple point that you dive off into dozens of other scenarios and lose sight of the main conclusion. Further, the more variables built into a model, the more the result becomes opinion. So, we’ve avoiding modelling narrowing discounts, or volatility or any of the other discount-related factors and just kept our discount at a constant to illustrate the underlying maths of reinvesting capital dividends. But let’s briefly think about discounts. In our example above we have two investment trusts only distinguished by their dividend policy. Over a ten-year period, which one is more likely to see its discount narrow? I think if a trust is paying a dividend, it will increase the chances it attracts more investors. But even if it doesn’t, if some of its existing investors automatically reinvest their dividends, then this creates slightly more demand for the shares. The golden answer to the age-old question ‘how do you narrow a discount?’ is to create more demand for the shares. So, I think, absent other factors such as good marketing, the trust paying the capital dividend has a higher probability of narrowing its discount.
This leads to the next question, which is if a trust goes to a premium, how does the maths of reinvesting dividends work then? The straightforward answer is that it doesn’t, because the investor is then, in effect, being handed a little piece of the NAV and using it to pay a higher price for the shares. I would make three points though. First, the discount has narrowed from 10% and then gone on to a premium. The returns generated from that will vastly outweigh the little compounding effect of dividend reinvesting and that’s a cause for celebration. Second, one can choose to stop reinvesting dividends at that point. Spend the money or reinvest it in something else. Third, history says that most investment trusts are much better at limiting premiums to low single digits than they are discounts. The maths of reinvesting a capital dividend at a tiny premium is, technically, unappealing, but the numbers are so small it’s probably not worth worrying about it. But of course, it’s one more thing to keep an eye on.
Let’s clear something up about revenue reserves
If none of that leaves readers persuaded, let’s think about it a different way. One of the oft-cited advantages of investment trusts are their ability to smooth dividends, using revenue reserves. I think this is, uncontroversially, a good thing. But know this. Revenue reserves are not, as the name perhaps implies, a stash of cash in a bank account. When an investment trust transfers some of its income to reserves, it becomes part of the net asset value, invested in the same portfolio. There is no special ring-fenced area where reserves are held. Revenue reserves are an accounting construct that keeps track of how much income the trust has received but hasn’t distributed, but the money is invested just like all the other money. So, if one purchases an investment trust with a large revenue reserve, that value is in the NAV and by extension the share price. So, the same argument that naysayers apply to capital dividends applies: the investor is being given money back that they’ve paid for. The difference is that the original source of that money was from portfolio company dividends, and again, that’s something that might matter to an investor. But if an investment trust with an NAV of 100p pays a dividend of 1p from revenue reserves, then the NAV is now 99p. Just like a capital dividend. Happily, all the other positive maths we’ve explored above also applies.
A few of the good ones…
Many investment trusts pay capital dividends and that tells us something important. While there are those investors who don’t like them, many do and are happy to receive them whether they have created an excel spreadsheet to prove they work or not. A portfolio built for income can only be helped by some diversification into key areas that, without capital dividends, an investor might not be able to access. This year, European equities have notably outperformed US equities and one of the strongest performing trusts in the Europe sector, JPMorgan European Growth and Income (JEGI) pays a dividend equivalent to 4% of NAV. JEGI’s objective is to be a risk-controlled ‘core’ investment and so although it does not seek out dividend paying companies, it is managed in a way that may well align with conservative equity income investors. In the adjacent European Smaller Companies sector, the aptly named European Smaller Companies (ESCT) is in the process of adopting a capital dividend policy paying 5% of NAV. In keeping with the times, ESCT is absorbing one of its smaller rivals, European Assets (EAT), which holds the record as the longest-running capital dividend payer and ESCT is adopting a similar policy, set at 5% of NAV. This will be a great way to get access to one of the best smaller companies trusts there is while receiving a dividend. Income investors who feel they are shut out from the long-term growth of China could do well to look at JPMorgan China Growth & Income (JCGI), which pays a dividend at the 4% of NAV rate. And drilling into more specific sectors, International Biotechnology (IBT) also pays a 4% dividend, and Polar Capital Global Financials (PCFT) has very recently adopted the same policy, again providing income investors with something they might otherwise not be able to access.
In conclusion
The elephant in the room is that capital dividends are not progressive dividends that gently increase each year, and an income investor needs to think about that. But in building a portfolio of several income trusts, the risk that the capital dividend might fall in a given year is balanced by the fact that it equally might increase significantly. The basic premise of investing in equities is, in any case, that their value rises over time, so taken on a ten-year view, one might see shorter-term volatility as a risk worth taking. The other, perhaps less expected, conclusion is that for investors who don’t care at all about dividends, buying a trust on a discount that pays a capital dividend might be a good thing, partly for the maths we explore above and partly for the increased probability of discount narrowing. Really, it’s as simple as breathing.
· The Company declared total dividends of 5.18 pence per share with respect to the period and paid a dividend of 2.50 pence per share with respect to Q4 2024 in the period.
· During the period the Company has bought back 35 million of its own shares at an average cost of 115 pence per share.
· Post period end, the Company announced part disposals of three wind farms for £181 million which will bring total divestments in the past year to £222 million.
· Aggregate Group Debt was £2,254 million as at 30 June 2025, equivalent to 41.5 per cent of GAV. Were the proceeds of the disposals announced today applied to debt repayment, pro forma gearing would stand at 39.5 per cent.
Commenting on today’s results, Lucinda Riches, Chairman of Greencoat UK Wind, said:
““The Board and the Investment Manager remain fully aligned with investors and continue to focus on driving long-term shareholder value through proactive capital allocation and active asset management. We are pleased to have announced further disposals, delivered at NAV, which will bring total divestment proceeds to £215 million.
Despite lower portfolio generation due to low wind, the Group delivered robust cash generation of £163 million to achieve dividend cover of 1.4x. The team continues to progress a number of key initiatives aimed at optimising asset performance and enhancing long-term value.
We are an established leader in the sector, with a simple, low risk and proven model, a substantial portfolio of high-quality assets, and an attractive net return for investors. We remain confident in our ability to deliver on our objectives of growing the dividend in line with RPI and capital preservation over the long term and extend our track record of outperforming our peers.”
Dividend Announcement
The Company also announces a quarterly dividend of 2.59 pence per share in respect of the period from 1 April 2025 to 30 June 2025.
One problem with charts is that they can be used to make a point. With QYLP above, they pay a high yield, so looking at the chart without the dividends gives a false impression.
When you include the dividends, which can either be re-invested into your Snowball or used to pay your grocery bill, the picture is entirely different.
Body or tail or both, the choice my friend is yours.
5 New Dividends in 2025 (Including an 8.8% Yielder)
Brett Owens, Chief Investment Strategist Updated: July 28, 2025
Brand new dividends are often the best divvies to buy. Here why.
Companies typically initiate a new payout when they are serious about it. This means not only is management going to make sure the dividend is adequately funded, but they are also likely to raise it in a year.
Perennial raises command our attention because these growing payouts tend to pull their stock prices higher. This is the “Dividend Magnet” phenomenon we often discuss and highlight in my Hidden Yields research advisory. The most lucrative stocks to buy today are the ones that are growing their payouts the fastest tomorrow.
Let’s welcome these five new divvies into the world—and explore whether they are worth our retirement capital.
Millrose Properties (MRP) made 2025’s biggest income splash by coming out of the gate swinging with an 8%-plus yield.
Millrose is a real estate investment trust (REIT), and an unusual one at that. MRP—which was spun off by homebuilder Lennar (LEN) in 2024 and started trading in February 2025—exists to buy and develop residential land, then sell finished homesites back to Lennar and other homebuilders through option contracts with predetermined costs. Lennar, for instance, will pay Millrose an 8.5% annual option fee.
This is a first-of-its-kind REIT, so we’ll need Millrose to register a few more quarters’ worth of results before we can really dig in and understand what normal operations are supposed to look like. But what we do know is that so far in its short history, everything is pointed in the right direction.
MRP is Serious About Dividends
An additional bonus that we can’t see in this chart? Millrose has already delivered a dividend hike.
Yes, the dividend line is pointed up and to the right, but that’s because MRP paid a prorated dividend in April before paying a full one in July. However, in its inaugural dividend announcement, Millrose noted that the 38-cent prorated dividend would equate to a 65-cent dividend on a normalized basis—meaning July’s payout actually represents a 6% increase.
MRP, welcome to our Contrarian Outlook watch list! I’ll be monitoring this stock to see if it is indeed a future fit for Hidden Yields or Dividend Swing Trader.
Bristow Group (VTOL) is a global provider of “vertical flights solutions” (read: helicopter transportation), operating a fleet of aircraft across six continents.
VTOL is technically an energy-sector stock, as its primary business (~70% of revenues) is providing helicopter transport to offshore energy customers. However, another 25% of its revenues come from providing search and rescue (SAR) and aircraft support solutions to government and civil organizations, and the remaining sliver of sales comes from corporate and other services.
Bristow Group’s roots go back to 1955, when the company was known as Bristow Helicopters. It has gone through several changes in ownership throughout the years, and it even was forced to enter Chapter 11 bankruptcy protection in 2019 after years of net losses. But it re-emerged as a public company in June 2020, under the ticker VTOL, when it merged with fellow helicopter operator Era Group.
Operationally, Bristow has shown significant improvement over the past few years. It finally turned a profit in 2022, and though it slipped to a thin loss in 2023, it followed that up with a spectacular 2024, delivering its biggest full-year bottom line in a decade. Management is confident that’s no fluke—or at least, that’s what we can reasonably assume given its February 2025 announcement that the company planned on initiating a dividend program.
But VTOL’s dividend announcement is one of the weirdest ones I’ve ever seen. Bristow said it will start paying 12.5 cents quarterly—starting in February 2026. That’s a full year’s worth of advance notice!
Maybe Bristow hopes a slow-boil hype cycle will give its stock some life. Nothing else has seemed to.
When we think about the “space” business, we typically think about self-storage REITs like Public Storage (PSA) and Extra Space Storage (EXR).
But WillScot Holdings (WSC) makes those companies look like one-trick ponies.
WillScot (not a REIT, by the way) designs, delivers and services on-site, on-demand space solutions. That includes jobsite trailers, portable container office trailers, temperature-controlled refrigerated trucks, blast-resistant modular buildings, and its “Flex” modular office solutions “that are vertically stackable for evolving workspace needs.”
A Temporary Two-Floor Office? Coming Right Up! Credit: WillScot.com
Space, as it turns out, is indeed a growth business. WillScot’s top line has been growing without interruption since 2017. Meanwhile, WSC flipped from annual losses to a profit in 2020 and hasn’t looked back—though those earnings have been extremely variable.
WSC Shares Have Been as Inconsistent as Profits
Not variable enough, however, to prevent WillScot from announcing its first dividend. In February, it announced it would begin paying a modest 7-cent quarterly dividend starting in March.
The short-term pain might not yet be done for WSC shareholders, either; full-year 2025 could see both the top and bottom lines contract, if the experts’ prognostications are correct. But even then, WillScot’s new payout is less than 20% of weak 2025 earnings projections, indicating plenty of room for WSC to become a more serious dividend player down the road.
Western Digital (WDC) Dividend Initiation Announcement:April 30, 2025 First Dividend Payment: June 18, 2025 Dividend Amount: $0.10 (Quarterly) Dividend Yield: 0.6%
2025 has also seen a few big blue-chip names kick off dividend programs, including Western Digital (WDC).
Western Digital develops, manufactures, and sells data storage devices and solutions based on hard disk drive (HDD) technology. Its products include internal, external and portable HDDs, data center storage and accessories.
It used to deal in NAND flash memory products, too, until February of this year, when it spun off that part of the business into a separately traded company, Sandisk (SNDK). If that name sounds familiar, that’s because Sandisk operated independently until 2016, when Western Digital bought it out.
In jettisoning Sandisk, Western Digital effectively lost the business (flash) with greater growth potential, but it retained the business (HDD) in which it has a roughly 40% market share and that still has plenty of drivers. Regardless, the broader memory business is an extremely cyclical one—WDC delivered substantial net losses in four of the past 10 years, including 2023 and 2024.
That’s part of why, despite drastically improving fundamentals and projections for robust profits for the next few years, it was a little surprising that Western Digital announced its first dividend just a couple of months after the spinoff—a 10-cent quarterly payout that was first distributed in June.
It’s also surprising because we’ve seen this rodeo before. Western Digital started paying 25 cents per share in 2012, and across several hikes eventually doubled that to 50 cents quarterly by early 2015. However, it had to turn tail and suspend the dividend in 2020 as it needed to invest more in its business and knock out debt.
The current dividend is just 8% of WDC’s projected earnings for 2025, indicating that under normal circumstances, we could be looking at years of fat dividend hikes to come. But the cyclical nature of memory and Western Digital’s past missteps has me wary of expecting too much out of this tech name.
Is WDC’s Dividend the Start of Stability, Or Is More Turbulence in Store?
Regeneron Pharmaceuticals (REGN) is one of the market’s largest biotech companies. Its best-known drugs include Eylea (for eye diseases), Dupixent (for asthma and eczema) and Libtayo (a cancer immunotherapy). Regeneron also works in rare diseases, inflammatory conditions and infectious diseases, using proprietary genetic research and antibody technology.
And this year, the longtime biotech winner finally decided to join Big Pharma in sharing its wealth with stockholders, announcing an 88-cent-per-share quarterly dividend starting in March.
But REGN sure picked an interesting time to do it.
Rarely Do We See a New Dividend While a Stock’s Being Cut in Half
Normally we’d expect a crash like that to be accompanied by a massive dropoff in sales and/or profits. But that’s not what we’re seeing here—at least not enough to justify hacking the stock in half.
2024: Revenues +8%, net income +12%
2025 (est.): Revs -5%, net income -22%
2026 (est.): Revs +6%, net income +11%
The primary concern has been rapid deterioration in sales of Eylea, which accounts for roughly a third of Regeneron’s sales. We can blame competition from Roche’s (RHHBY) Vabysmo as well as several biosimilars. More recently, the stock was also hit when it suffered a surprise Phase 3 trial failure for a COPD drug it has been developing with Sanofi (SNY).
As with any pharma company, a hit to a blockbuster drug only has so many fixes—sometimes it’s additional indications for that drug, but often it’s simply finding replacements from the pipeline. Unfortunately for Regeneron, it could be a few years before it can fully counter what it’s losing from Eylea.
REGN might see stabilization soon—again, sales and profits are expected to rebound in 2026, and its valuation is now cheaper than the broader health care sector. And the dividend? Even including 2025’s expected declines, the payout accounts for just 10% of earnings, so it’s not unreasonable to think REGN could offer us a traditional pharma-esque yield on cost a few years down the road.
What I Wish I Knew Before Investing In Dividend Stocks
Jul. 26, 2025
Samuel Smith
Summary
Dividend investing has been extremely rewarding for me.
However, I have learned several very expensive lessons along the way.
I share four very important – yet seldom discussed – lessons in this article.
Looking for a portfolio of ideas like this one? Members of High Yield Investor get exclusive access to our subscriber-only portfolios.
magical_light
Dividend investing has been a wonderful experience overall for me, in addition to learning a lot about the world and its major corporations, as well as learning a lot about myself, I have managed to enjoy significant total return outperformance of the S&P 500 (SPY), thanks to implementing a valuation and fundamentals-focused opportunistic capital recycling strategy. That being said, I have also learned quite a few costly lessons along the way. With that in mind, in this article I am going to share four lessons that I wish I knew before investing in dividend stocks.
Lesson #1
The first major lesson is that dividend stocks tend to be relatively poor long-term compounders, though of course there are some exceptions. The reason for this is that stocks that pay dividends, especially high yields, do so in large part because they have limited opportunities to reinvest and retain cash flows at high returns. Therefore, while they may present attractive current income and may even grow at a rate that meets or beats inflation over time, they are unlikely to be highly dynamic growers due to their limited retained capital. These are the sorts of stocks you see in a lot of high yield sectors like REITs (VNQ) such as Realty Income (O), business development companies (BIZD) such as Ares Capital (ARCC), MLPs (AMLP) like Energy Transfer (ET), and even some consumer goods companies like Altria (MO).
Of course, some of these do have very impressive long-term total return track records; however, most of their peers lack such impressive long-term compounding performance, and in the case of companies like O and ARCC, it is largely due to the fact that they have at times traded at premiums to their underlying NAVs, which enable them to issue additional shares on an accretive basis to accelerate the compounding process. Meanwhile, stocks like MO were able to grow their earnings per share at a strong clip for years with a powerful moat, but their moat is now rapidly eroding as their core smokeables business is experiencing huge volume declines and they are struggling to grow out of it.
All that to say, when you are investing in a portfolio of higher-yielding stocks like this, capital recycling needs to be a part of your strategy if you truly value long-term total return performance. The inability to reinvest a lot of capital at high rates of return makes these companies limited from a long-term compounding perspective, especially compared to dynamic growth and innovation stocks like Microsoft (MSFT), Meta (META), and Tesla (TSLA) that are constantly developing new technologies and retaining the vast majority of their cash flows to pursue growth opportunities. This is evidenced by the fact that the S&P 500 and the NASDAQ (QQQ) have significantly outperformed dividend stocks, as evidenced by comparing their performance relative to the Schwab U.S. Dividend Equity ETF (SCHD) over the long term:
Another important lesson that I wish I had learned before investing in dividend stocks is that certain types of dividend stocks can be either extremely tax inefficient or extremely tax efficient investment vehicles, depending on which accounts you hold them in. For example, REITs, BDCs, and MLPs are all pass-through entities, and so they are largely exempted from corporate income taxes, which can make them extremely tax-efficient investment vehicles.
However, BDCs primarily invest in loans, so the vast majority of their dividends are classified as ordinary income. Given that the vast majority of the total returns they generate tend to come from the dividends themselves, since they have to pay out at least 90% of their taxable income as dividends to maintain their status as BDCs, they are very tax-inefficient to hold in taxable accounts. However, these investment vehicles are excellent to hold in a retirement account, since the dividend tax classification is meaningless, while the underlying business itself is largely tax-exempt.
REITs are a bit more complicated, as some of their payouts do count as return of capital, and they also qualify for a 20% QBI deduction in many cases. So, depending on the REIT’s dividend yield and the classification of its dividend, it could be a good fit for a taxable account, or in other cases where much of the dividend is classified as ordinary income and has a high yield, it is likely much better suited to holding in a retirement account.
Finally, MLPs that issue K-1 tax forms are much better suited to taxable accounts, since the distributions are largely classified as return of capital, making them very tax-efficient income instruments for a taxable account, whereas if they are held in a retirement account, they can generate UBTI, which could force you to pay a tax bill in an account that is supposed to be tax-sheltered.
Beyond that, dividend stocks, as previously mentioned, are not the best wealth compounders, so capital recycling is often a useful strategy to overlay on top of them. This is particularly true since they tend to be easier to value than high growth stocks, because you simply look at the yield for a large portion of the return and then add to that some relatively modest yet highly predictable growth rates to determine what kind of total return you are going to get from the investments. Therefore, if you do plan on implementing a capital recycling program with stocks, it is best to hold as many of them as possible in a retirement account in order to mitigate the tax headache that can come from frequent selling positions at short-term capital gains rates. Note that none of this is tax advice, rather simply my opinion based on my years of experience dealing with tax-related issues from investing in dividend stocks. Be sure to do your own diligence and speak to your own tax advisor before making any of these decisions.
Lesson #3
Another lesson I wish I had learned before investing in dividend stocks is that it is very important to understand what type of dividend stock you are investing in. For example, if it is a cyclical stock, you need to be extra careful because they can often experience sharp declines in earnings as you head into down cycles and, with it, a deep decline in the stock price. If the balance sheet is not particularly strong, this can lead to steep dividend cuts or even dividend eliminations, as I learned the hard way with Hanesbrands (HBI) and some investors who are currently in Dow (DOW) are currently learning the hard way as well.
Meanwhile, if it is a stalwart, steady stock like Enbridge (ENB), IBM (IBM), or NNN REIT (NNN), you can count on very dependable dividends, but you are not going to get much in the way of growth. As a result, these are the sorts of stocks you need to make sure you buy on a value basis and will likely want to implement a capital recycling program on to accelerate the compounding process if total returns are important to you. Meanwhile, stocks that have lower yields but high dividend growth rates are ones that can generate a lot of wealth, but you need to be careful because once the dividend growth rate slows meaningfully, the stock is likely going to pull back sharply as well. Just look at what happened to the late NextEra Energy Partners (XIFR) as an example of this.
BDCs, MLPs, and REITs generally tend to belong in the stalwart category, yet their underlying mechanics are quite different in terms of how they relate to macro factors. BDCs tend to benefit from rising short-term interest rates, whereas REITs tend to suffer when interest rates rise. MLPs, meanwhile, are much more commodity price sensitive in terms of unit price performance, even if their underlying cash flows are quite stable. Therefore, you need to make sure you realize these factors when buying these securities instead of just looking at the yield that they offer and ignoring all the other considerations that go into those investments.
Lesson #4
Finally, I wish I had known that high-yield funds are often fundamentally flawed. This is because it is very rare for a large portfolio of stocks to offer a sustainably high yield such as these high-yield funds offer. Yes, you can find perhaps one or two dozen high-yield stocks at any given time that have genuinely sustainable high yields and compelling valuations. This is what I do, in fact, in my portfolio.
However, many of these other funds are very broadly diversified, and so they generate their yields from less sustainable sources. One way they do this is by selling covered calls as the JPMorgan Equity Premium Income ETF (JEPI) does, which often leads them to long-term NAV erosion risk as evidenced by the abysmal long-term performance of the Global X Nasdaq 100 Covered Call ETF (QYLD).
Another way they can do this is by filling their portfolio with very low-quality underlying holdings, which get exposed whenever the markets experience a downturn. An example of this is the VanEck Mortgage REIT Income ETF (MORT), which has seen its dividend payout decline meaningfully over time.
Another option is that they may employ significant leverage risk, which can juice returns in the short term and enable them to pay out a higher yield, but also puts them at significant risk during a market crash. This is especially common in the closed-end fund space, where piling on significant amounts of leverage is quite common, as seen with funds like the PIMCO Dynamic Income Fund (PDI), the Cohen and Steers Quality Income Realty Fund (RQI), and the Cohen and Steers Infrastructure Fund (UTF). Note that some funds can navigate carrying significant leverage quite well, but the risks are still elevated when this route is taken.
Finally, there are other funds such as the Liberty All-Star Equity Fund (USA) that pay out a high yield yet generate that yield entirely from the proceeds of selling underlying positions rather than actually generating it from dividends from underlying holdings. This exposes them to significant sequence-of-return risk and/or dividend cut risk because if the market were to ever enter a prolonged bear market, they would either significantly erode their NAV and lock in permanent losses on their underlying holdings or they would have to cut their dividend. Either of these outcomes should be a major no-go for investors looking for long-term, sustainable, and growing passive income.
Investor Takeaway
Realizing that many dividend stocks are actually pretty poor long-term compounders, that they can be potentially extremely tax-inefficient investments if you do not understand what you are doing, that they can also lead to dramatic downside risk both in terms of share price performance and dividend payouts if you do not understand what type of dividend stock you are investing in, and that high-yield funds are often yield traps due to some fundamental flaw are some very important lessons that I have learned the hard way as a dividend investor over the years. However, it is important to keep in mind that each of these challenges can be mitigated or avoided altogether while still reaping the long-term wealth and passive income compounding that comes from dividend investing. Hopefully these lessons are useful for you as you craft your own dividend portfolio, as they are invaluable to me as I build my portfolios of high-yielding, high-performing stocks at High Yield Investor.
The Snowball never intends to kill the Golden Goose but to use the income generated to provide retirement income.
Realty Income (NYSE:O) is a favourite stock among investors looking for passive income. And with a monthly dividend that’s increased quarterly for over 55 years, it’s easy to see why.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice.
Dividend income
At the moment, 30-year government bonds yield 4.9% in the US and 5.4% in the UK. Compared to that, Realty Income shares look like a very attractive passive income opportunity.
The stock currently has a 5.6% dividend yield. And the firm has increased its distribution at an average of 4.2% per year since listing on the US stock market in 1994.
Past dividend growth doesn’t guarantee future increases. But Realty Income’s impressive track record hasn’t come about by accident – it’s the result of skilled management.
Hidden costs
The first thing UK investors need to keep in mind is taxes. Distributions from US companies are subject to a 30% withholding tax, though this falls to 15% for investors with a W-8BEN form.
In the case of Realty Income, it means the 5.6% yield is actually more like 4.75%. That means UK investors should expect a lower starting return than government bonds currently offer.
Inflation is another issue. Both the Bank of England and the US Federal Reserve are aiming for 2% currency depreciation per year, which would cut the starting return to 2.75% in real terms.
That’s less than half the 5.6% investors might have initially expected. But the bigger problem is that the annual dividend growth rate has slowed to 2.2% over the last five years, rather than 4.2%.
Long-term returns
A starting yield of 5.6% with 4.2% growth is very different to a starting yield of 4.75% with 2.2% growth. And the contrast can be quite dramatic over a 30-year time period.
The higher number is what UK investors might hope for from a £10,000 investment in Realty Income shares. But I think the lower one is a more realistic expectation in real terms after taxes.
That’s why it’s important to pay attention to the various factors that can weigh on real returns. Sometimes investors can find themselves getting much less than they initially expected.
US stocks
I used to have a big (by my standards) investment in Realty Income. The reason I don’t any longer is that I think I’ve found better opportunities in the UK.
Over the long term, I’m not sure the potential returns are exciting. A combination of inflation, a slowing growth rate, and withholding taxes make me wary of what I might get back
Could be one to DYOR if you want to pair trader it with a higher yielder to lower your overall risk. The current target yield for the snowball is 7%
