Dividends, the income which comes from many stocks, are in a middle of a renaissance. Back in the roaring ‘90s, dividends took a back seat to appreciation—the growth in a stock’s price. Well, now people’s attitudes have changed. It was bound to happen after the tech-bubble burst, the recession, and the 50% loss in the value in stock indexes. The financial crises including the Great Recession and excess of 50% loss in stocks continued to fuel the change.
That’s good and bad.
It’s good because dividends are an important part of the stock story. Depending on how and when you measure them, they are responsible for one-quarter to one-half of the stock market’s total returns. To say the least, that is significant. For most people, dividends come at a cheaper tax hit than income from bonds and such because of the tax law surrounding “qualified dividends.”
It’s bad in that dividend payments don’t make sense for a number of companies. If you are a newer firm, or one with continuing growth needs, that cash is likely best spent to hire more workers, build more production lines, and optimize your automation.
It’s very bad when the only criteria an investor uses in picking a stock is the dividend payment. Not only are you eliminating a large swath of the stock universe from consideration, high levels of dividends can create excess risk in a portfolio. This comes as a surprise to those who think that dividends equal safety.
While there are several areas of risk that you need to consider when buying any stock, two come to my mind first when dealing with dividend payers. The first is sector overweighting. High dividend payers in the past have included REITS (real estate investment trusts), Utilities, and Financials (think banks). Putting most of your eggs in these baskets left you vulnerable to extreme movements during the financial crisis, real estate collapse, and deregulation.
The other area of risk is comes from that fact that in order for a company to pay a dividend, they have to get the money from somewhere. We already talked about how this can dampen a company’s ability to grow. In addition, there’s a chance that a company might pay out so much of its cash that they wouldn’t be able to maintain in times of crisis. Some, to ensure they didn’t have to cut dividends, have even resorted to borrowing money to then pay out to shareholders.
In other words, it’s a good idea to ask yourself three questions if you find that all or a majority of the companies you own pay dividends: 1) Is this hurting their ability to keep up with their competition? 2) Do they have enough cash after paying to handle potential problems? And 3) Is my portfolio too concentrated on just a few sectors of the economy?
Dividends and dividend-paying companies have their merits, I like them. I’m just not so in love with them that my heart takes control of my head. For example, my head tells me that just because a company has been paying out dividends every year for the last two decades doesn’t mean it can or should do so next year. Yet another reason for diversification.