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Why you need to read this before you buy dividend stocks

If you are looking to get into the share market, then many investors will start looking at those that pay juicy fully franked dividends.

But there are some warnings investors need to heed. Not all dividends are equal. There are some disadvantages buying companies that pay out most or all of their earnings as income.

And finally, there are some surprising advantages to investing in dividend-paying stocks.

Dividend stocks may not grow as fast as others

If a company is paying out most or all of its earnings as dividends, then theoretically, it means the company has less retained earnings to put back into growing the business. Smaller companies that are growing fast need every available dollar they can get their hands on to sustain that growth. Paying out a dividend makes little sense in that case.

Larger, more mature companies may also pay out more in dividends because management struggle to reinvest that cash at decent rates of return.

Take Telstra Corporation Ltd (ASX: TLS) as an example. The company pays out virtually all of its earnings as dividends because it struggles to generate growth in revenues of more than 5% each year. That’s mostly because of its dominant position in Australia and as a mature business.

Dividend stocks may be more stable and reliable

Paying out regular, consistent dividends means companies can establish a price floor underneath their share price. Once the share price sinks to a certain level, bargain hunters and income investors start swooping on the stock, pushing the share price back up again.

High growth companies that don’t pay out much in the way of dividends could see their share prices fall further if they struggle to maintain growth rates the market has come to expect. Without that growth and with little or no dividend, investors start worrying where the investment gains will come from.

Dividend stocks can boost your portfolio by more than you might expect

If you thought dividend stocks would slow the capital gains in your portfolio then you might want to think again. According to Ned Davis Research in the US, from 1972 to 2016, dividend stocks averaged an annual gain of 8.8% versus just 2.2% for the non-payers.

Ned Davis Research dividend stocks

Source: Ned Davis Research

And as we’ve often argued, companies that pay out dividends tend to have greater capital discipline than those that don’t and have been proven by many studies to outperform over the long term.

Dividend stocks need to be chosen carefully

Investors can’t just go out and pick the companies with the highest trailing dividend yields (dividend divided by price). For one, there’s a very good chance they are unlikely to be able to pay out the same dividend amount in the year ahead.

Among some of the highest yielding companies on the ASX are companies in the mining services sector. Monadelphous Group Limited (ASX: MND), Cardno Limited (ASX: CDD) and Decmil Group Limited (ASX: DCG) all have yields over 10%. But that figure is based on last year’s dividend which they are unlikely to be able to meet this year. Their revenues and earnings have been falling consistently and will likely fall again this year.

Investors also need to pay attention to payout ratios and whether the dividend is franked or not. Franked dividends can generate a higher after-tax return.

Foolish takeaway

Don’t be put off from buying dividend stocks by those last few comments. Every portfolio should have a decent allocation towards dividend paying companies – but just be aware of some of the pitfalls.

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Motley Fool writer/analyst Mike King owns shares in Telstra Corporation. You can follow Mike on Twitter @TMFKinga

The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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