Dividend Delusions

This blog is inspired by a client who recently asked what our thoughts were about an article titled, “3 Safe Dividend Funds Averaging 8% to Buy Today and Hold Forever.” This is a pretty fair question, considering that the article claims these funds both yield 8% AND are safe. Why would we waste our time buying bonds that yield only 3%? We’ve gotten questions like this from clients in various forms over the years, so it makes sense to spend some time discussing the subject.

First, there are some huge misconceptions when it comes to dividend stocks we need to clear up. All else being equal, there is no benefit in owning a stock that pays a dividend versus one that doesn’t (in fact, adjusted for taxes it could be worse…but that’s a separate discussion). If a company generates profits, they have to make a decision about what to do with those profits. They can either pay them out in dividends, buy back their stock or reinvest in the company. If the company has good growth prospects, wouldn’t you want them to reinvest in the business rather than pay a dividend or buy back stock?

People often view dividends as an extra return you get on top of owning the stock itself, like a “super stock.” This is not the case. When a company pays a dividend, the price of the stock is reduced by the amount of the dividend.  You don’t get BOTH the dividend and the current price of the stock, otherwise that’s all we’d own!

Another common misconception is that a higher dividend paying stock is necessarily better than a lower dividend paying stock. Let me give an example of what I mean. When companies decide to pay a dividend, they give a dollar per share amount, not a set percentage. Let’s say Stock A has a $100 price and pays a $5 dividend. That means it has a yield of 5% ($5/$100) per year. However, if the price of the stock goes up to $200, and the company still pays the $5 dividend, it now only yields 2.5% ($5/$200) …Did the company’s stock become less desirable because the yield went down? Assume the opposite, that the $100 company has some bad times and its price is now $50. The dividend is still $5, so it now has a yield of 10% ($5/$$50). Does the fact that this stock now pays a 10% dividend make it a better company?

Of course, it’s certainly possible that the stock has become more attractive, as you are buying at a cheaper price. However, you just need to understand that the reason your yield is so good is because it’s been a terrible stock, and investors are pricing in continued hardship. Markets are very efficient, which means that it’s very difficult to get a high return without taking commensurate risk. The market is not going to give you a free 10% yielding stock on a good company. You only find these when you look in the trash.

Historically, looking for higher dividend stocks has actually been a good strategy, because high dividends are a signal of beaten up stocks which are cheaper (they tend to be value stocks). However, dividend yields are just one of several ways to identify value stocks, so it shouldn’t be your only criteria.

So far, I’ve only covered dividend stocks, but the exact same principles apply to bonds. Why not just buy a 15% yielding bond? I can assure you plenty exist. Verdad Capital recently wrote a great piece on this called Fools Yield, where they look historically at the returns of investing in bonds with different credit ratings. The chart below shows the yield you can get on bonds of various credit ratings from best (AAA) to worst (CCC3). AAA bonds are currently yielding about 2.8% while CCC3 bonds are yielding 12.2%.

Obviously, any investor would prefer the high yielding bonds. However, notice the historical returns, shown in solid blue. They return about the same, and this is before even considering the type of volatility you’d have to endure, much less the reduction in diversification you’d get by adding them to your portfolio (high yield bonds are highly correlated to stocks). My goal is not to convince you that there is something “bad” about high dividend stocks or high yield funds. On the contrary, these can be valuable pieces of a portfolio. However, these yields need to be put into context.

At WJ, we focus on achieving a high “total return,” and yield is only part of that equation. The other is price appreciation/depreciation. Sure, your dividend stock or high yield bond fund might pay you 8% in yield, however, you only get that return if the price stays flat, and there are no defaults.

I started this blog by referencing an article highlighting “safe dividend funds averaging 8% to buy today and hold forever.” Two of the three funds existed during the great recession in 2008. During that time the stock dividend fund lost 75% of its value peak to trough, while the bond dividend fund fell 64%. I don’t know about you, but that doesn’t fit my definition of “safe.”