It seems like everyone these days is advising folks to invest in stocks with high dividends. The advice for dividend investing rests on the idea that companies with good dividends tend to be larger, more stable, and better managed than those that don’t…basically, less risky. Given today’s market concerns, “less risky” certainly resonates with investors. And, in today’s low-yield bond environment, many people are looking to these companies to replace the income they normally expect from the bond side of their portfolio. Lastly, so the logic goes, even if the market moves sideways for several years at least your stock portfolio will be paying you something while you wait for the markets to start going up again.
So is there anything wrong with that logic? For starters, many of the companies in the high dividend category are there because their stock price is so depressed that any dividend will be a larger percentage of its stock price than it normally would (dividend yield, the measure used to compare one stock’s dividend to another, is calculated by dividing its annual dividend by its current stock price). That’s not necessarily bad if the stock price is irrationally oversold, but what if it’s not? This is the inherent risk of value investing, that the stock price is low for a reason and likely to stay that way. If it’s low because the company is truly in trouble, not only will the stock price stay low or go lower, but the company may very well cut its dividend as it tries to fix the company. Hopefully, good research can help avoid that outcome, but many have tried and failed disastrously.
What about the idea that high dividend companies are more stable and better managed than others? This is simply one of those statements that is overly broad and unjustified. While many of the high dividend firms are quite stable and well managed, there is certainly no evidence that it is the case for all or even a significant number of them. And even if it were, things change all the time so that there is no way of knowing whether that will be the case a year from now – companies change, management changes, stock prices change, dividends change, etc. And large, stable companies, while sounding great in a volatile stock market environment, don’t necessarily offer the longer term growth that most stock investors desire. They have a much harder time consistently offering the double-digit growth that many want and need if they expect their portfolios to give them the retirement nest egg they want to have. Consider a company with $100 billion in market capitalization…how likely is it to grow another $10 billion next year (a 10% gain), and then $11 billion the next (another 10% gain), accelerating each year just to offer similar percentage gains in stock price?
As for the logic behind replacing yield from investors’ bond portfolios, that might work for a little while, but eventually bond yields will normalize and when that happens, money will likely flow back into bonds, creating downward pressure on those stock prices as it moves from one to the other. The income one receives in dividends over their holding period could very easily be given back in capital losses down the road. Using stocks to replace yield in bonds is a dangerous notion and one that investors should seriously consider before doing so.
Finally, those managers who are building portfolios out of those large and supposedly stable high dividend stocks are doing so from a very limited universe. Of the nearly 5,000 non-real estate, US-domiciled stocks trading on the NYSE/AMEX/NASDAQ, only 53 have dividend yields of 3% or greater as of this writing. Again, that may not be a bad thing, but concentrated portfolios are considered riskier than diversified ones, which is contrary to the logic behind dividend investing.
So, before you get too excited about the latest idea from investment “professionals”, think about all the angles. I doubt most of those “pros” have.