Today’s low interest rates have investors searching for yield. As the S&P 500’s dividend rate of 2% hovers around the 10-year Treasury bond’s yield of 1.7%, bonds no longer seem the easy answer. Bond investments may let you sleep at night, but their return, especially when factoring in inflation, will not help investors reach their retirement savings goals. The Fed’s recent rate reduction has reinforced this perception, increasing the appeal of dividend stocks.
Investing in dividend paying stocks has long been a strategy to generate income and enhance total return. The classic investment principle is that companies paying dividends are optimistic about both their financial position and growth prospects.
For an investor, dividends offer a tangible connection to a company’s performance and future prospects. Traditionally a dividend paying company tends to be one that is more mature and successful with its business model, finances, and operations. The company is often generating significant cash flow. The dividend also signals future confidence from management, linking the return on that business to shareholders in a very practical and public way. This aides in valuation, connecting the payment stream with the underlying fundamentals of the business
Research shows companies that increase their dividends consistently outperform other stocks. They also exhibit lower volatility. Dividends often provide a large and stable portion of a stock’s total return.
Utilities, consumer staples, and financial companies historically have been large dividend payers. However, bank stocks had their ability restricted following the financial meltdown in 2008 and the resulting limitations the Federal Reserve placed on their balance sheets.
As recently as August 2019, 60% of the stocks in the S&P 500 offered a yield exceeding the 10-year U.S. Treasury, which was then at 1.65%. While rates have moved up and down, the S&P still has an average yield of 2%. This continues to propel the stock market, as the TINA effect (“there is no alternative to stocks”) kicks in.
Besides yield, some of the other appealing features of dividend stocks include:
Give an investor a choice in redeploying the steady income stream – Investors who want to generate a predictable cash flow love the stable and consistent income stream dividend stocks provide. In addition, dividends put a portion of the company’s return on capital in your hands to reinvest as you wish. This is the opposite of having the company decide to purchase assets overseas, make an overpriced acquisition, buy back shares, or undertake some other action you may not agree with.
Mitigate some market risk - Dividend plays tend to do well in an uncertain and defensive market. When investors get skittish and market returns fall, the onus often rests on dividends to drive total stock returns. Morningstar calculates that dividends contributed to 19% of the S&P 500’s return for the past five years, a bullish period for the market. Depending on the time period you select, the contribution can be more. BlackRock estimates reinvested dividends have explained almost 50% of the S&P’s rise for the past 30 years. In periods of significant stock declines, such as the 1970s and 2000s, dividends were the only returns investors received.
Protect against inflation - Dividends can also help counter the effects of inflation and protect purchasing power, especially if a company has a dividend payout rate that exceeds the inflation rate. You may perceive getting a “raise” in spending power when companies increase dividends during inflationary periods. Normally, fixed income investments, except for inflation protected Treasuries, lose ground to inflation.
Improve tax outcomes - Interest from bonds and other fixed income investments is taxed as ordinary income at your highest marginal tax rate. Qualifying dividends will be taxed, along with capital gains, at a lower rate. Most dividends from US stocks should qualify for this treatment. Stocks held in taxable accounts can take advantage of the maximum current 15%-20% federal tax rate on stock dividends.
Dividend stocks are not always an investor’s best option. Thing to be considerate of include:
A high yield may be a function of a falling share price – use caution. Investors should not be buying high yielding stocks without doing their homework. Because dividend yield is a function of dividend rate over share price, a fall in the latter makes the rate look more attractive. If the share price is falling for reasons that may jeopardize operating performance and future earnings, the stock should be avoided. Look under the hood of the company and understand what is driving the lagging share price.
Rising rates – Dividend stocks may underperform as interest rates rise. Rising rates can hurt dividend paying stocks in several ways. First, investors often view these stocks as a proxy for bonds and drag down the value in sympathy with bond prices. Second, investors may move to alternative fixed income products with a superior credit profile and rating. Finally, a rising rate environment often signals a stronger economy, which favors growth stocks versus dividend payers.
A market that favors growth stocks - When the market enters its more active bull phase, dividend companies are often viewed as those stodgy old grandparents, slower-moving and graying around the edges. The more mature nature of the investment puts it at a disadvantage to its younger and faster-moving growth cousins. Safety and security go out the window and these companies may trail the market.
The dreaded dividend cut – During the bear market that commenced in 2008, S&P companies cut their dividends by 24%, led mostly by financial firms. That was mild compared to what happened during the Great Depression when dividends were cut by 47%, even accounting for the period’s deflation. Dividend cuts impact valuations. However, in both cases the dividend cuts were not nearly as severe as what happened to overall equity prices.
Investing in dividend stocks can be a profitable strategy. The goal is to provide a reliable cash flow stream and stability to a portfolio during volatile market times. However, there is no guarantee of outperformance as different investment strategies work better at various points in the market cycle. You may outperform during volatile or down market periods, but underperform when the markets heat up. Finally, purchasing a stock for its dividend only is a risky strategy. Do your homework and find the solid company that has demonstrated an ability and commitment to grow its dividend.
Note: Elaine Phipps, MBA, CFA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
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