Beware of Owning Stocks Solely for the Dividend

 | Sep 25, 2013 | 6:00 PM EDT
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I've stated on numerous occasions that most investors today underestimate the value of dividend payments. Over the past century, nearly one-half of the annualized market return has been due to dividends. If you examine blue-chip names like Johnson & Johnson (JNJ) and their share-price performance over 10-, 20- and 30-year periods, you'll see the dividend has been an instrumental part of that total return.

This fundamental value of dividends will not be going away. But that value, evident in names like J&J, is a result of a couple important characteristics: consistency in payment and growth in payout. Here, the sum benefit of consistent and growing dividends is immensely greater than each part is in isolation. What good is a growing dividend if it's not consistently paid? If a dividend payout has no chance of growing, meanwhile, it might be a sign of the business' long-term inability to grow cash flows. So isolated dividends may not be as attractive as one may deem. Remember shipping stocks back in 2007?

But today, another factor -- one that I believe is being underestimated -- compounds the existing reasons to be careful about stocks known only for exceptional dividends. With today's extremely low interest rate environment, other riskier assets become more attractive. In the absence of risk-free return from the likes of savings accounts and U.S. bonds, investors gradually shift into the alternatives -- stocks and bonds.

Dividend stocks occupy a special place in the market: The existence of a long, stable dividend serves as an investment signal to many investors. In a low-interest-rate world, companies that pay out even higher relative yields -- master limited partnerships, real estate investment trusts and other trusts designed to return income back to owners -- become even more attractive. When interest rates start to move back up, that dynamic shifts, and it can do so quickly. For companies that are chosen more for their yield than for the underlying strength of the business, this happens in layers.

First, it's simply a matter of risk and opportunity cost. As risk-free rates increase, investors will demand higher rates of return from riskier investments. A five-year certificate of deposit (CD) that pays 5% a year risk-free makes a 2.5%-dividend-paying stock less attractive.

Yet, for businesses whose mainstay is to return most of their cash flows to shareholders each year, there is a double problem: Their sole appeal to investors is the payout. That's unlike, say, Apple (AAPL) today, which not only offers a 2.5% yield but also the prospects of continued future growth. These high-yielding enterprises almost always require consistent levels of debt to fund their operations. As interest rates move up, the cost of debt will also increase. Absent a commiserate rise in business activity, cash flows available for payouts will go down.

Indeed, this was evident when it was announced that the Federal Reserve may be increasing interest rates. The worst-performing stocks were generally high-yield equity securities.

So, from here on out, it would not be wise to reach for dividends just for the sake of the yield. 

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I reached out last week to my close friend Ken Shreve, who is a prominent writer for the IBD.  I asked Ke...
I reached out last week to my close friend Ken Shreve, who is a prominent writer for the IBD.  I asked Ke...
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