The second circle of my money machine are investments that pay a high direct return of cash, whether it be dividends or interest. This has led to exploring the various types of income-paying investments, which I list and describe here.
Something I've learned is that a company that pays a dividend generally is better run and more stable. The dividend becomes part of the expectation the shareholders have from the company, and the management knows to operate the company so that the dividend is paid on time every time. Often if dividends are cut or not paid, the stock price immediately dives, making a huge incentive to company management to keep the dividend flowing.
In todays era of ENRONitis, corporations where cheating has become the norm and the profit/loss figures in the SEC filings may be inflated in various ways, cash payments are reassuring. Cash cannot be a lie, and is a hard indication that the figures in the SEC filings are fairly accurate.
On this page I'm going to discuss dividends as opposed to interest. These are two distinct classes of payment, though both ultimately are a cash flow going to the investor. Most of what I say on this page applies to both dividends and interest. Interest is payments resulting from loaning money to another, and dividends are payments resulting from ownership.
Dividends are calculated in two ways. First you have the absolute dollar amount of the dividend. This is the amount the management "declares" as the dividend. Dividends are usually paid quarterly, but not always.
The yield is cited as a percentage, and calculated this way:
yield = ( dividend / current price ) * 100
Obviously as the current price varies, so does the yield. It's an inverse relationship, meaning that as the stock price rises the yield lowers (assuming the dividend stays the same).
Taxes and "double taxation"
Corporations pay taxes on their corporate income, just as we individuals pay taxes on our personal income. However when a corporation pays a dividend the cash counts as "income" to those who receive the dividend. Thus the individual shareholders in turn pay taxes on the dividend amount.
Through a peculiar line of reasoning the "investing class" claims this is double taxation. They have been pushing for decades for an "end to double taxation". That's nice for them. They did eventually achieve a partial end, in that beginning with the 2003 tax year "qualifying" dividends are now taxed at a 15% rate rather than at the full rate the individual would pay.
Real Estate Investment Trusts (REIT)
REIT's are a specific type of corporation, the form being enacted through a series of U.S. laws. A REIT is required to own and operate real estate as its primary activity, REIT's must pay out 90% or more of its taxable income as dividend, and as a result REIT's do not pay taxes at the corporation level. Individual shareholders do pay taxes on REIT dividend income. The dividend payment and tax requirement sidesteps the "double taxation" issue described above.
Investing in a REIT is a great way to get into real estate investment without having to actually own the real estate outright. Generally real estate investment (as opposed to home ownership) has two goals, the first is direct income from renting the property to others, and the second is the general increase in land value over time. One could buy an investment property (say, an apartment building) directly, but then you become a landlord and have a lot of property management issues to deal with. Maybe you want to be a property manager, and that would be a good route to follow for real estate investment. REIT stocks offer a different way, to get into the real estate game without getting your hands dirty so to speak.
Investing in REITS: Real Estate Investment Trusts by Ralph L. Block
Ralph has for a long time done investment analysis specializing in REIT's, and is also a frequent contributor to the Motley Fool REIT discussion board.
Royalty trusts are another specialized form of corporation that pays high dividends. They are generally a passive holding vehicle that represents a something that pays a royalty, and most of the these trusts represent some form of resource mining operation. By "resource mining" I mean oil or gas drilling.
The taxation issues in royalty trusts are very complex. So complex that I have not bought into any, even after studying a few.
Mergent's Dividend Achievers index
Founded in 1979 this is an index tracking corporations that have been paying dividends, and regularly increased their dividends for at least 10 years. This definition neatly encapsulates "Dividend Growth Investing", where the observation is that shareholders getting regular payments are likely to remain loyal to a stock if the dividend is kept up. If the dividend is regularly increasing, this increases their loyalty.
Regularly increasing dividends have another effect, that the effective yield increases over time. By effective yield I mean this:
effective yield = ( dividend / price-paid ) * 100
Ignoring the current price, what is the yield you get based on your original investment? That yield increases only if the dividend is increased. For example I've noticed that WRE, a REIT that has been paying dividends for over 40 years, always has a yield of around 4-5% (low for REIT's) but the stock price has only gone up for the 40+ years the stock has traded.
More information: http://www.dividendachievers.com/
ETF's specializing in Dividend Achievers: PED, BDV, BDT