Investors love dividends, and for good reason. Getting paid to hold a profitable stock is always an added bonus, and dividends receive preferential tax treatment too, being capped at a 23.8% rate. However, dividend yields are greatly misunderstood by many. Many investors think of dividend yields as a return on invested dollars, thus a higher yield implies a better investment. In some ways we are programmed to look for recurring cash inflows as a means for survival, making this lesson a little hard to digest. But a good understanding of how to think of dividends can help deliver better investment results while meeting your income goals.
Let’s start with the basics – why do investments or assets earn an income? For a risk-free treasury bond, the income is a compensation for parting with current liquidity. You are parting with a hundred dollars today to receive back the hundred at a future date. If that future date is a year from now then you earn an income of two dollars for the year; if it’s ten years away then you can earn almost three dollars each year. Thus, the longer the commitment, the higher the income. Now what if there were risks involved and you didn’t know if you would get your $100 back at the end of the first year or $95? You would certainly demand a higher income as compensation for not just parting with your money today but also for accepting the risk of a five-dollar loss on your capital. Junk bonds do just by that paying an income of six dollars per hundred.
For stocks the analysis becomes much more complex. The amount you get back at the end of your investment horizon could be less or more than what you put in. The promised income at the start might grow, decline or be eliminated at any point as well. So the correct way to compare a stock and a bond is not just based on the annual income but also where the stock ends up after your holding period. We can’t accurately predict stock prices, but a simple approach is to assume that the stock price will grow in-line with its dividend or earnings growth. So a company paying a 2% dividend yield and growing at 10%, might actually deliver a 12% return. A large portion of that return is derived from growth and only a fraction from the dividend. On the other hand, you could have a company paying a 12% dividend yield but not growing at all still deliver a 12% return. In reality there are various other factors that drive stock returns but it’s important to note that dividends are just one of them. The one company paying the lower dividend with equal return also compounds better since a smaller portion of the return is exposed to annual taxes, albeit at a low rate.
As a shareholder you don’t just have claims on the dividends but on all cash flows (defined as Free Cash Flow – FCF) the company generates after paying other stakeholders (suppliers, employees, bondholder etc). Dividends are usually paid as a fraction of FCF while the rest is either reinvested in the business, kept as cash or used to repurchase shares. For years, pipeline MLPs were the dividend kings. But the downturn in energy prices exposed a darker side, where dividend payments exceed FCF. This usually causes rising debt to keep from slashing the dividend and is not sustainable. In comparing one company versus another, the FCF yield is a better indicator. Dividend yield alone will only give you part of the full picture of a company’s health.
The next question is – can a high dividend yield demonstrate a company’s confidence in its business? We have certainly found that a steady and growing dividend is a good indication of a quality company that has confidence in generating future cash flows. But a very high yield and no growth can be a pretty good indicator of future dividend cuts, stock declines, and possibly a carrot being used to keep investors from selling their ailing stock. In the stock markets there are no free lunches and a stock yielding over 6% is often too good to be true. Higher yielding stocks often come with more volatility and have historically underperformed the markets when you look at total returns (dividends plus stock performance). Here are examples of several ETFs that focus on higher yielding companies versus the S&P 500 (SPY). Notice the relationship between high yield and low overall performance, and vice versa.
Shares of QDF, which picks its “best” dividend paying stocks using other criteria such as profitability and cash flows, has been a great performer although it still lagged the S&P 500 over this period. All others have lagged substantially and with higher risk (as measured by Standard Deviation).
For those who do not require income from their investments, dividends can be a further drag since they generate taxes. The same value compounded in share price (capital gains) generates taxes only when a stock is sold. They also have to be periodically reinvested. This is why Warren Buffett does not allow a dividend to be paid from his behemoth; Berkshire Hathaway. If you do need the income the most secure option is to buy bonds with low returns. But what if bonds alone don’t yield enough income and you are willing to take some risk to generate a higher income? Then equities could certainly be suitable, but again going back to the basics, dividends should be just one selection criteria. Then how do I get the yield I need? Here is a simple approach to get you as much income as you require. If you need 10% on your investment, buy equities that pay a 2% dividend and sell 8% of your initial investment each year. Markets will always be volatile so it’s best to supplement this with some bonds so when markets crash you can sell those bonds rather than selling stock. In highly liquid markets with low transaction costs it’s easy to get the cash you need, when you need it. This will also be more tax efficient as you pay taxes only on the gains portion of what you sell. Remember also that withdrawals over 5% over long time periods have greater odds of taking a toll on your portfolio. High withdrawal rates (i.e.10%), are really only for those in the likely final decade of their life.
Wall Street is quick to create investment products that are tailored to generate higher yields. They are usually able to get away with charging higher fees for such products as well. While everything with a high yield is not a bad investment, we would suggest you do your homework and look at various other factors other than just dividend yields. There is an old saying that goes: “Any investment offers a combination of return, safety and liquidity, but no investment can offer all three at the same time, pick any two”. Bonds are safe and liquid but offer low return. Stocks are liquid and offer return, but without safety. Custom building your portfolio using a combination usually offers the greatest peace of mind, leading to long holding periods that compound return while minimizing taxes.
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