The Problem with Dividend Stocks
By Saghir Aslam
Rawalpindi, Pakistan

 

(The following information is provided solely to educate the Muslim community about investing and financial planning. It is hoped that the Ummah will benefit from this effort through greater financial empowerment, enabling the community to live with dignity and fulfill their moral obligations towards charitable activities)

Investors have pushed up their prices so high that they may not be worth buying right now

Dividends are so important for stock returns that they once prompted one of the founders of fundamental stock analysis to write a poem about them.

Cash payments from stocks included the lines: “cow for her milk, / A hen for her eggs, / and a stock, by heck, / for her dividends”

These days, however, analysts would be hard-pressed to wax poetic about dividend stocks. The problem: Investors, desperate for yield with interest rates so low, have driven up the price of dividend stocks to lofty levels.

 

Dividend stampede

Famously low bond yields have encouraged a stampede into stock funds that invest in dividend-rich companies. Fund companies typically close a fund to new investors when the portfolio is in danger of getting too unwieldy to manage—the fund-industry equivalent of a fire marshal putting a limit on the number of people allowed in a room.

The main REIT indexes have risen 200% since the end of the financial crisis. One reason for this, in addition to the general rebound in real-estate prices since the 2008-09 crash, is that real-estate investment trusts are high-yielding stocks, and the funds that own them, therefore, come with prodigious yields. The trusts pay out 90% of their net income as dividends in exchange for tax-free status at the corporate level. That has made the funds that own them particularly attractive to mutual-fund investors—and to former bond investors in today’s low-yield era.

Simple math will tell you that a 10-fold increase in the size of the Vanguard REIT Index fund, after a threefold investment return, means investors are throwing dollars at the fund. Based on the fund’s investment return and its current asset level, investors have tossed more than $40 billion into the fund since 2009.

What actually is happening, market watchers say, is that investors looking for yield are stuffing these REIT funds with new money as a result of bond yields being so low.

 

Expensive valuations

The yield on the 10-year U.S. Treasury fell below 4% in July 2008, before the worst of the financial crisis, and it hasn’t been back in that range since then. It sits at 1.6% now. Also, more than $13 trillion of foreign government bonds offer negative yields.

 

But as investors move from low-yield bonds into dividend-paying stocks, are they going from the frying pan into the fire?

Though the Research Affiliates proprietary U.S. dividend index reached its most overvalued point in late 2011, when the comparison period included the depths of the 2008-09 stock-market crash, it has remained more expensive than its long-term average for much of the period since 2009. Morningstar Inc.’s market-evaluation tool, meanwhile, finds widespread overvaluation of stocks in several sectors where higher dividends are paid.

 

How much can you get paid?

Investors looking for stocks with comparatively high yields today often find them in big, established companies that sport consistently high returns on invested capital and stable earnings. These often include consumer-products companies, but can also include established tech companies. Top holdings of Vanguard Dividend Growth Fund include Microsoft Corp., Nike Inc. and Costco Wholesale Corp. The fund currently yields 1.9%.

Of course, dividend funds that specialize in REITs and utilities do manage to offer slightly higher yields. Companies in those sectors tend to grow slowly and be more capital-intensive than the average company, and thus find it necessary to keep their investors happy with higher-yielding dividends. Vanguard Utilities Index Fund (VUIAX), which has nearly doubled in size from $1.7 billion in late 2013 to $3.2 billion this year, currently offers a yield of 3.1%; iShares Select Dividend ETF (DVY), which has 29% of its portfolio in utilities stocks, currently yields over 3%.

 

Risk vs. return

The bottom line is investors who chase these yields now do so at the risk of buying into an overheated, overvalued corner of the market. Indeed, the perceived safety of dividends does not extend to the stocks themselves. Declines in a stock’s price can far outstrip the value of its dividend yields. That makes for an investment that loses money overall.

Bonds can produce negative total returns too, when interest rates rise. But stocks—even dividend-paying stocks—are a far more volatile investment. And that can make dividend-focused mutual funds a particularly challenging proposition for investors switching into them from bonds.

The 15-year standard deviation of returns for the Barclays U.S. Aggregate Bond Index through July 31 was 3.47%. That means the index’s returns mostly deviated from its average return by 3.47 percentage points. By contrast, the standard deviation of returns of Vanguard Dividend Growth fund over the same period was 12.46%.

Another concern, whether you’re a short-term or a long-term investor: Though companies are reluctant to do it, they can always cut dividends if profits aren’t high enough to cover them.

Companies are paying more of their profits as dividends than they have since 2009, according to Fact Set data cited by The Wall Street Journal last month. Some may borrow to maintain dividends, if profits aren’t sufficient. But that strategy can self-destruct as more debt is required, since companies must pay interest on debt before they pay dividends to stockholders.

Dividend-paying stocks may do better than bonds over the next decade, though not by much. And while they are fine as part of one’s stock allocation, substituting them for bonds and cash can create more portfolio volatility and a smaller return than investors may have bargained for.

(Saghir A. Aslam only explains strategies and formulas that he has been using. He is merely providing information, and NO ADVICE is given. Mr Aslam does not endorse or recommend any broker, brokerage firm, or any investment at all, nor does he suggest that anyone will earn a profit when or if they purchase stocks, bonds or any other investments. All stocks or investment vehicles mentioned are for illustrative purposes only. Mr Aslam is not an attorney, accountant, real estate broker, stockbroker, investment advisor, or certified financial planner. Mr Aslam does not have anything for sale.)

 

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Editor: Akhtar M. Faruqui
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