Dividends – the Good and the Bad

                                                                                                                                                                                                                                                                                                                                                                Gary Silverman, CFP®

Dividends, the income which comes from many stocks, are in a stalled renaissance. Back in the roaring ‘90s, dividends took a back seat to appreciation—the growth in a stock’s price. Then, after the tech-bubble burst, the recession, and the 50% loss in the value in stock indexes investors began thinking that dividends might just be nice to have. The financial crises, including the Great Recession and another excess of 50% loss in stocks continued to fuel the change. 

That’s good and bad. 

It’s good because dividends are an important part of the stock story. Depending on how and when you measure them, they are responsible for one-quarter to one-half of the stock market’s total returns. To say the least, that is significant. For most people, dividends come at a cheaper tax hit than income from bonds and such because of the tax law surrounding “qualified dividends” which I won’t take time to explain. 

It’s bad in that dividend payments don’t make sense for a number of companies. If you are a newer firm, or one with continuing growth needs, that cash is likely best spent to hire more workers, build more production lines, and optimize your automation.  

It’s very bad when the only criteria an investor uses in picking a stock is the dividend payment. Not only are you eliminating a large swath of the stock universe from consideration, high levels of dividends can create excess risk in a portfolio. This comes as a surprise to those who think that dividends equal safety. 

While there are several areas of risk that you need to consider when buying any stock, two come to my mind first when dealing with dividend payers. The first is sector overweighting. High dividend payers in the past have included REITS (real estate investment trusts), Utilities, and Financials (think banks). Putting most of your eggs in these baskets left you vulnerable to extreme movements during the financial crisis, real estate collapse, and deregulation.  

The other area of risk comes from that fact that in order for a company to pay a dividend, they have to get the money from somewhere. We have already talked about how this can dampen a company’s ability to grow. In addition, there’s a chance that a company might pay out so much of its cash that they’d have trouble in times of crisis. Some companies have even resorted to borrowing money to then pay out to shareholders so that they didn’t have to cut their normal dividend distributions. 

In other words, it’s a good idea to ask yourself three questions if you find that all or a majority of the companies you own pay dividends: 1) Is this hurting their ability to keep up with their competition? 2) Do they have enough cash after paying to handle potential problems? And 3) Is my portfolio too concentrated on just a few sectors of the economy? 

Dividends and dividend-paying companies have their merits, I like them. Just follow my example and don’t fall so in love with them your heart takes control of your head.