Dividends! Myth?

[TBPu]

I need a serious logic check on my thinking. Thanks.

I flirted with a portfolio of 90% "high dividend yielding stocks. It seemed reasonable but I heard a comment today by Suze Orman on Today. She told a caller roughly, "right now CDs, treasuries, etc are so low in yield that a good dividend stock is a better choice for income production. Because, no matter what happens to the stock price you still get the dividend."

OK, yes, she is not a Bogle. But that attitude seems prevalent.

But doesn't investing in a dividend payer have additional risks.
1. Risk to NAV
2. Risk to reduction of dividend payout.
3. ** And if the NAV decreases then the yield "seems" to be "hhigh" but it needs to be factored by the reduction in NAV

Example
$100 initial value in VWxx yiedling 4.0% should produce $4.00 per year
But if the NAV drops by 20% then the $80 current value produces only $3.20.

So the dividend sounds great when advertised as 4% but it could be "net" 3.2%.

Would appreciate any comments that clear me up on this seeming contradiction to buying dividend stocks.

 

[Notmuchlonger]

Do companies tend to cut their dividends in a down environment? I wouldn't say cd's and treasury's are THAT low either. Im not so sure about that Suze Ormon. This is one of those cases I think she is making alot of assumptions. My 2 cents anyways.

 

[haha]

There ae several threads that say about all that can be said about this topic.

The short answer to your question is, "Yes, of course you can lose if you get a 4% dividend and your stock goes down=>4.1%.

It's a strategy, not a magic trick.

ha

 

[Gworker]

There was an article in last months Money magazine about dividend paying funds and how you would have more money if you invested in them than if you invested in the S&P 500. Here's a quote from the article and link:

High-yield stocks outlast the S&P...If you retired before the 1973-74 bear market with $500,000 in high-yielding stocks and withdrew 4.5 percent initially, you wouldn't have depleted your nest egg - far from it....they give you room for error...Even if you needed more income and withdrew 5 percent the first year, that portfolio of high yielders would still be worth more than $2 million today....and they eventually produce more income than bonds.High-yielding stocks initially pay less than bonds, but the annual income they generate swells over time thanks to dividend growth...

It was a rather short article but it made it seem like that was the way to go but I don't know if they did enough research and compared it for different time periods or just certain time periods.

Here's a link to the rest of the article:

Coming out ahead when high-yield stocks plunge - Dec. 6, 2007

 

[mn54]

Ask those investors that bought wash. mutual for the high dividend before they cut the dividend and the price of the stock sank.

 

[Hamlet]

This strategy can certainly work, but it comes with some risk, and some challenges.

Risk #1-- Dividends can go down. You can get a higher total return by investing in dividend stocks instead of CDs, but you can also lose out.

Risk #2-- It can be hard to diversify. If you look at stocks that are currently high-yielding, they are concentrated in only a few sectors. Banks are high-yielding right now because people are afraid that people aren't going to be able to pay their mortgages. Drug stocks are high-yielding because their pipelines appear weak, and they are facing patent expirations. People are worried that REITs are going to face falling real estate values.

Risk #3-- You can lose your principle. A stock can go down and never come back. Can't happen with a CD.

That said, to a large degree I use this strategy. I like dividends. I look for a large, growing dividend in as many of my investments as possible.

 

[TBPu]

haha,
I must have missed something. My question really was exactly your comment. Is dividend investing not magic as some want to suggest but simply a strategy that has additional risks. Risk to NAV and risk to change in dividend amount.

It seems to be a myth that dividend yielders are a panacea for market fluctuations.

 

[ziggy29]

I think it's a valid strategy and relatively safe if:

(1) You select 10-20 stocks so no one failure or dividend cut is a killer;

(2) You select companies with a very solid history of raising dividends over time;

(3) You are very diversified in sector (i.e. don't have 6 of your 14 stocks be banks).

I think if you do all of these you will occasionally stumble on one or two companies struggling to maintain their dividends, but overall with well-diversified sectors and companies that regularly grow dividends, the chances of really getting burned are minimized. That's at least true for a very long term buy and hold approach designed to eventually produce an income stream in retirement. If you won't be holding them for most of your life, then loss in stock value or NAV is a greater concern.

 

[terminator]

Risk to NAV and risk to change in dividend amount.

Bonds have "NAV" and payment risk too, just typically less of it.

Example
$100 initial value in VWxx yiedling 4.0% should produce $4.00 per year
But if the NAV drops by 20% then the $80 current value produces only $3.20.

Not sure what you mean. If NAV drops to $80, the dividend is still $4.

If you want to use a dividend strategy you either need to be competent to analyze a company's financial position or you need to buy a dividend oriented fund (like DVY, PEY, PFM, SDY, CVY, etc.). Like anything else, it depends on your tolerance for risk. Older and need certainty? It's probably not for you. Little margin for error in your plan? Maybe not for you.

I fear inflation more than I fear the vagaries of the stock market.

 

[TBPu]

Thanks for the comments. I believe the myth is exposed already.

Gworker, thanks and yeah that is the kinda "rah rah" article I saw constantly but like you point out, they chose exactly one example to justify recommending that strategy. I see some strange new behaviour and Prof Shiller says it best. This ain't 1969. Things have changed.

mn54, exactly the reasoning I saw. Everyone one cautions "past performance is no..." and then those same people way look at what VWxx had done with dividends. Yeah, that was "past performance". Just like Wash. Mut.

hamlet, "rich gifts wax poor when givers prove unkind" my favorite line. I appreciate your candor and yet thou doth seek a lean and gaunt visage.

ziggy, have struggled to do just what you suggest. Any picks?

 

[Nords]

Thanks for the comments. I believe the myth is exposed already.

Part of the problem in any of these studies is survivor bias.

If your backtesting strategie owned AT&T before the Ma Bell breakup, your portfolio today wouldn't exactly look like a dividend champ (although it would have done well). Dogs of the Dow has only been around since 1991, and it has periods of scary underperformance that would test the mettle of any investor. So your mechanical investing strategy would benefit from some rebalancing rules, leaving you open to tinkering temptation.

We're quite happy with the DVY shares we bought at $55 and we've been reinvesting the dividends since March of 2004. However we rebalanced a bunch more into DVY last summer at $67 which has proven to be substantially less than brilliant. Reinvested dividends will pull that one out after 15-20 years.

I wish the attached article wasn't about Berkshire (because I don't intend to shill the stock) but its Strattec example is a very good explanation of dividends vs growth.

To create value at a cash flow machine you can do one of three things:
1) turn it into a compounding machine (like Buffett did at Berkshire)
2) turn it into a dividend paying machine, or
3) turn it into a EPS growth machine, either by growing the business,
or buying back shares at low prices (relative to earnings).

Is Berkshire Hathaway Worth More Dead or Alive? - Seeking Alpha

 

[unclemick]

Before computers, spreadsheets, modern portfolio theory and people playing with themselves via the killer app(a little curmudgeon wisdom) - they used to do it the old fashioned way:

1929 - Wellington
1931 - Dodge&Cox Balanced

And yes(what an easy pitch) - Wellesley 1970!

Balanced with some fixed income, the value premium, dividends.

Now the modern cats will bring up TWD. But that's another test.

The real question is why you want to push toward higher div yield versus Ben Graham's the middle way - most people miss this one - only took me twenty yrs to figure out what he was telling me - div.'s plus div. growth in a durable as in been around a long time company with a chance of staying that way.

heh heh heh - if you are in the accumulation phase broad low cost index will probably win.

 

[megacorp-firee]

Do companies tend to cut their dividends in a down environment? .

In my experience, not unless they are in for a prolonged earnings slump or other problem that they need to divert some of their dividend payment monies. In other words, a temporary issue will not cause them to lower their dividend payment. A major problem will.

 

[RunningBum]

But it's not easy to spot a major problem coming. IBM was one of the quintessential blue chip companies, with a steadily rising dividend. Stock started sinking...ah, but look at the yield on that dividend! And they've never cut it, so you can't lose!

Stock kept slipping, and it turns out the company really was in some trouble, and the dividend was cut heavily.

Ultimately IBM did something else it had never done before, layoffs, and with new leadership turned things back around, but it took some time.

As others have said, it's a good strategy, but don't go in with blinders on.

 

[CyclingInvestor]

But it's not easy to spot a major problem coming. IBM was one of the quintessential blue chip companies, with a steadily rising dividend. Stock started sinking...ah, but look at the yield on that dividend! And they've never cut it, so you can't lose!

Stock kept slipping, and it turns out the company really was in some trouble, and the dividend was cut heavily.

Ultimately IBM did something else it had never done before, layoffs, and with new leadership turned things back around, but it took some time.

As others have said, it's a good strategy, but don't go in with blinders on.

Usually the signs are there, and with IBM they were pretty strong. Their earnings peaked out in 1985
at around $6.5b, flopped around throughout the rest of the 80's between $3.7b and $6b, then posted
losses by the billions for the next few years before they cut the dividend in 1993.

 

[ats5g]

Personally, I think the whole high-dividend strategy is just another value strategy, primarily a large value strategy. My past analyses of funds like Vanguard's Wellesley, Wellington, and Equity Income showed me that any of their "alpha" or excess return could've been duplicated by a simple large value tilt. And as ziggy29 noted, a lot of the high-dividend strategies/funds are concentrated in one or two sectors, not too mention that only about 25% of firms actually pay dividends.

- Alec

 

[terminator]

Funny you mention IBM as an example. It was one of the first stocks I ever bought. The dividend was cut, nay slashed . . . I think by 75%, a few years later. I look at it today, 17 years later and my personal yield on it is about 7% on the original investment. That is, it's better than a bond. (Not to mention the 400% or so return.) And that's a *bad* example of dividend investing which went very wrong.

Dividend investing is easy and makes sense, but it's not for everyone. Some people prefer to focus on market risk instead of inflation risk and they are more suited to fixed income investments.

 

[clifp]

Thanks for the comments. I believe the myth is exposed already...


ziggy, have struggled to do just what you suggest. Any picks?

At the risk of being a shameless shill for Morningstar. I think the M* Dividend Investor newsletter is worth taking a look at. The editor Josh Peter also has a brand new book out about Dividend Investing.

I will agree that a significant risk of a dividend strategy is sector concentration. For instance of the 29 stocks in the two (Harvest and Builder) real money portfolios 9 are banks or financial companies, 4 are classic REITs, and 6 are involved in energy transportation (primarily pipeline companies) and in fact the portfolio barely eeked out a postive return last year due to the financial sector cratering.

On the other hand the builders portfolio currently yields over 4% and harvest portfolio is 8% and neither has seen a dividend cut yet. In fact have seen something in the neighborhood of 70 dividend increase in the last 2.5 years resulting in an income increase of 7% per year.

Alec may very well be right that that magic of dividend is largely illusionary. Still I sleep a bit better at night with dividend stock. I know that barring a continue collapse in the financial sector my income should remain quite steady without worrying about a bear market effect my withdrawal rate. Further more if inflation raises its ugly head, MMM, Johnson&Johnson can increase most prices of their products, Compass Minerals can raise the price of rock salt, and Kinder Morgan can increase the price it charges to deliver oil, and natural gas to keep up with inflation.

 

[TBPu]

Great stuff. I think the responses are better reading than most books on the subject. A balanced view with no agenda.

My need is a relatively steady income and I have over the last few weeks considered almost every version of owning dividend yielding stocks to accomplish that goal.

The "all" dividend approach which no one here seems to favor.

The "no" dividend approach and just rely on havesting capitol gains.

The middle way as unclemick suggests.

The analysis was along the lines that nords points out. And the AT&t vs ETF vs BRK-B is still my dilemma.

clifp points out good performance in dividend fund but also notes a changing in dividents by 70% and that is great if upward. But it does illustrate the a dividend has a potential for two sources of volatility (stock price and dividend slashing).

And ats5g commenting on value tilting as a means of producing the same alpha makes me wonder if Wellesley could have outperformed itself had it took a value tilt under it's same management team.


So is it fair to say that this phrase is wrong: "just buy XYZ which pays 5% dividend and the ups and downs of the market don't matter". A easy sleep approach. Or do you really need to be diligent and research often to spot the "IBM" signs of impending dividend slash.

CDs would be risk free except for inflation and I think inflation can be managed to some extent. In other words. For instance, buy a slightly less fancy car, or select a higher deductible insurance if healthy. Market risk can't be managed.

Oh well, guess putting in my order and heading off on the boat is gonna require an internet connection.

Thanks for those posts, with a little editing they would make a good Money article. No wait, your posts were balanced and free of shilling so it would never publish.

 

[ats5g]

And ats5g commenting on value tilting as a means of producing the same alpha makes me wonder if Wellesley could have outperformed itself had it took a value tilt under it's same management team

Well, whether it was intentional or not, Wellesley has always taken a value tilt through its focus on higher dividend stocks. High dividend stocks are merely a subset of what are commonly referred to as value stocks, which are usually identified by such metrics as:

1) low price/book
2) low price/earnings
3) low price/dividend [inverse of div yield]

And if any outperformance associated with a high dividend strategy can be explained by its simple value tilt, then there's nothing special about that high dividend strategy, and I can get similar returns and be more diversified by just owning a whole lot of value stocks.

Here's a chaper from Aswath Damodaran's book Investment Fables: Exposing the Myths of "Can't Miss" Investment Strategies:

High dividend stocks: bonds with price appreciation

- Alec

 

[RunningBum]

Wellesley right now is just 36% in stocks. I don't know what the historic mix has been, but right now most of it's yield is coming out of bonds, not dividend paying stock.

 

[REWahoo]

Wellesley right now is just 36% in stocks. I don't know what the historic mix has been, but right now most of it's yield is coming out of bonds, not dividend paying stock.

36% equities is right where Wellesley should be. From the Vanguard website:

"The fund [Wellesley] invests approximately 60% to 65% of its assets in investment-grade corporate, U.S. Treasury, and government agency bonds, as well as mortgage-backed securities. The remaining 35% to 40% of fund assets are invested in common stocks of companies that have a history of above-average dividends or expectations of increasing dividends."

 

[ats5g]

Wellesley right now is just 36% in stocks. I don't know what the historic mix has been, but right now most of it's yield is coming out of bonds, not dividend paying stock.

your point?

 

[Calgary_Girl]

There's a guy in Canada by the name of Derek Foster who retired at 34 relying on dividends to fund his early retirement. He's been retired four years now and has published two books on the matter.

Yes, there are some risks with this strategy but Mr. Foster advocates buying only quality, recession-proof companies that have a track record of increasing their dividends over time to keep up with inflation.

In Canada, you can receive a little over $4K per month from dividends and pay almost zero tax since we have a nice little thing called the Dividend Tax Credit.

 

[kcowan]

The dividend hawks that I have talked with say that if you are in retirement and can live off the dividend yield from your portfolio, then you can ride out market dips and ignore NAV. In the long run, your stocks will return inflation protection where your CDs will not.

Can you ride out dividend cuts? If not then you will start eating into principal and the approach might come apart at the seams. But CD yields could also drop and force you to eat your principal. So it seems that the strategy would work best if you have extra principal to ride out the down periods. So maybe it works if your SWR is 3% rather than 4%?

Of course this conclusion is not too profound. You will be OK with most strategies if you have more money than you need. But if the Fed ends up dropping its rate down to 2.5% to stimulate the economy, maybe the dividend approach will beat CDs. IOW you will gain an advantage from siding with the central bankers.