One basic criterion for buying a security is how that issue fits into an investor’s overall investment plan–that is, how it helps meet his goals and objectives, whether it falls within his risk tolerances, and whether he is willing to expend the time and effort needed to research and monitor the position. (This third aspect is, in my opinion, the one that investors most commonly overlook.)
Looking at dividend-paying stocks, I think the main conceptual issue is the possible tradeoff between getting the highest current income and getting the best total return. You may not be able to do both. If your primary need is to generate, say, a 4% current yield from the US stocks you hold, you can probably do that, but chances are that you’ll underperform the S&P 500.
That shouldn’t be a big deal, since your aim is to produce steady income, not generate capital gains. It only becomes one if you forget–or don’t understand in the first place–what your primary goal is.
Why should an income-oriented strategy underperform?
In theory at least, prevailing prices express the aggregate market preferences for dividend yield and potential capital appreciation. In the US at present, this preferences are for a 2% dividend yield and a forward PE of about 12 . To tilt my personal portfolio away from the market by a little bit, by trading some capital appreciation potential for extra current income, I should not have to give away much more than I receive. But as I try to trade more and more appreciation for income, other participants in the market become increasingly reluctant to accommodate me, since doing so would move them farther away from their desired portfolio mix. So I have to “sweeten” any deal by offering increasing amounts of capital appreciation to get an extra unit of dividend income. Therefore, I start to underperform.
That’s the argument, anyway.
By the way, I think in today’s market it may be possible for an income-oriented strategy may do better than one might think. Several reasons:
–I imagine the movement of investors reaching for yield by moving from one part of the fixed income market to another as being kind of like the tide coming in. First it was government bonds, then corporate debt , then junk, now gimmicky things like century bonds. The wave hasn’t hit the equity market yet. But maybe it will.
–dividend haven’t been important in the US stock market for twenty-five years. Arguably, if/when the wave hits equityland, it’s not going to be as efficient as it might be.
–as far as I can see, there isn’t very much good research information about dividend-paying stocks around.
If so, great. It would be icing on the cake—but not by itself a compelling reason to concentrate on dividend-paying stocks.
how I’m choosing
In today’s US markets:
the two-year Treasury yields 0.46%
the ten-year Treasury yields 2.7%
the thirty-year Treasury yields 3.9%
the S&P 500 yields 2%
the forward market PE is about 12, meaning an earnings yield of 8%.
a first step
Over the past thirty years, the dividend yield on the entire stock market has only been higher than the coupon on the long bond during periods of extreme market stress–and even then only for brief periods of time. March 2003 and March 2009 were the only two instances over the past decade.
We’re obviously not in that position today. But still, in a less than 4% long bond world, there’s got to be some point beyond which a high dividend yield is an indicator of potential trouble–of potential investor worry that the dividend can’t/won’t be maintained at the current level.
Let’s say that point is a 6% dividend yield–above which one must tread very carefully. As a matter of stock triage, unless you are willing to spend the time doing careful research you may want to discard these high yielders as too good to be true (although as you’ll see below, they may merely be stocks with little hope of capital appreciation).
Let’s work out three simple examples to try to distinguish among the various types of dividend-paying stocks that are available in today’s market. They are:
1. an 8% dividend yield, no earnings per share growth
2. 4% yield, 5% average annual eps growth
3. 2.5% yield, 15% annual eps growth.
We’ll take a five-year investment horizon and assume that all of the stocks pay a constant percentage of profits in dividends and that none enjoy PE expansion or suffer PE contraction. To make the arithmetic easier, let’s also say that the initial price of each issue is $100.
Stock #1: at the end of five years, the stock price remains $100. The owner has received $40 in dividends. The stock yields 8% on the $100 purchase price.
Stock #2. The fifth-year stock price is $$127.70. The owner has received $21.83 in dividends. The stock yields 5.1% on the $100 purchase price.
Stock #3. The terminal stock price is $200. The owner has collected $16.88 in dividends. The stock yields 5% on the $100 purchase price.
the differences–objectives matter
Stock #1 generates by far the most income. Even the fast-growing #3 will not be matching #1 on a current payout basis for close to another five years. #2 won’t be doing so for at least a decade.
On a total return basis, #1 and #2 are within striking distance of one another.
Stock #3 is the total return winner. It does so on the basis of its capital gain, which, in turn, rests on its ability to generate above-average growth for an extended period of time. It produces only a third of the income of #1. A #3 also takes a lot more careful monitoring.
My investment personality orients me toward #3, but then I’m content to wait five years for serious income to start to kick in. But I also own one or two #3 types, understanding that they may underperform, because of the income they produce.
There are specific risks associated with every stock.
For these general sketches, it seems to me that the risk in #1 is that the company cuts the dividend, either because it can no longer afford to pay at that high level or because management decides to use the money that would otherwise be returned to shareholders in an effort (usually futile) to expand.
For #3, the risk is that the company can’t sustain a 15% growth rate for longer than a few years. As its business matures, it may turn into a #2. As it does so, its PE would likely contract. This means capital appreciation will be lower than the simple projection above anticipates.
who are they?
Do instances of these three general forms exist? Yes.
#1s are probably European banks or telecoms.
#2s are gas or electric utilities.
#3s are harder to find. They’re maybe TIF, or WMT, or maybe even INTC.