Chasing Yield: Not All Dividends Are Created Equal
I think one of the most common misconceptions that investors have is the value of investing in dividend-paying stocks. I hear this quite a bit from people who call me or email me and try to tell me the virtues of putting money into what they call “high quality, dividend-yielding securities.” And they can sound enticing – sometimes 7, 8, 9 percent dividend yields or more. Even lower yielding stocks, say 4, 5, 6% yields, may reflect stretched valuations and therefore may pose greater risk than perceived. But just because a stock is paying a high dividend does that mean it’s a great investment for you?
Some people believe that dividend-paying stocks do better during market downturns. But do they really? Take General Electric, which was paying a quarterly dividend of $0.31 per share in 2008. In 2009, as the market had come crashing down, GE cut its dividend to $0.10. And GE wasn’t the only one. According to Money Magazine and US News, 57 percent of dividend-paying companies, located in 23 developed markets, either reduced their dividends or eliminated them altogether. (source)
Going after companies and basing your investment decisions solely on their dividend is what’s known as “chasing yield.” These investors jump toward high-dividend stocks like a game of “Whack-a-Mole,” only to get burned when that dividend yield gets cut or eliminated. Remember, there’s no such thing as a free lunch. An investment will not pay 7 percent in a 2 percent world unless some element of risk is involved.
In fact, new data from BNY’s Mellon Capital shows that over the past 20 years, companies that offered at least a 10 percent dividend yield actually paid out only around 3 percent over the next 12 months. (source)
A better strategy is to also consider the fundamentals of a company in conjunction with absolute yield. Do the earnings and cash flow of the business ”cover” the dividend being paid? Is the dividend being funded by increasing debt levels and a deteriorating balance sheet? Exxon is a great recent example. Currently, Exxon is paying out 55% more than it actually earns and its debt has increased by over $10.6 billion, or 32%, in the last year. Is it really “too big to fail?” Instead of being drawn in simply by the lure of a high-dividend yield, look at those companies that are GROWING their dividend at a healthy rate, supported by string underlying fundamentals. Some of these companies may have a lower absolute yield, but if that dividend is growing due to fundamental strength and not strictly financial engineering, you might be looking at a much better stock. Remember, over time, you cannot pay out more than you earn – a good thing for all of us to remember.
There’s no shortage of financial press headlines telling you where to find high-yielding investment opportunities. But take a step back, and know that yield-chasing rarely ends well. Whether it’s stocks or bonds, once the inflection point happens, it’s just a matter of who’s left holding the bag.