I often hear people say that they don’t need bonds in their portfolio because they have dividend bearing stocks. This is not the correct way to view dividend bearing stocks.
What is a Dividend?
So, what exactly is a dividend? Dividends are payments a company provides out of their cash to shareholders on a periodic basis. The key here is the payment of this cash is in lieu of its usage somewhere else. Therefore, any money spent on a dividend is money not reinvested in the business, used to pay down debt, or invested in other businesses. This could be a good or a bad thing.
A Bad Dividend Situation
When evaluating a company’s dividend situation, people commonly look at their historical dividend payouts. This is a poor indicator as past performance does not necessarily guarantee future performance. It also ignores that dividend yield is not the same as return over this period, as outlined by WhiteCoatInvestor in a recent post here. The dividend may have stayed constant but the stock could have declined during the same period.
A better measure of dividend health is the dividend payout ratio. The dividend payout ratio is the fraction of earnings paid in dividends to the portion placed into net income in the same period. This shows how much the company is earning in profits versus how much of those profits they are putting out in dividends.
This tells you something very important. When a company pays a dividend are they paying out of current earnings, their profits, or are they paying by borrowing money? The dividend payout ratio can be a sign that a company is providing a dividend that is unsustainable. A number >1.0 means they are taking a loan to pay the dividend. It can also tell you if the majority of their earnings are going into dividends. A number >0.75 may indicate they are not investing adequately in their business, instead preferring to provide dividends. This can impact the long term health of the company. It is important to take the ratio as a comparison to those of other companies in the same industry. If you find one company with a high ratio and another with a low ratio in the same industry you should investigate further.
Where do Dividends come from?
I know you’re now saying, “But the company I’m buying has a good dividend payout ratio so I should be good, right?” Well, maybe not. You see, dividends are paid out of earnings and on hand capital. If a company’s earnings decline due to a recession this leads to either an increase in the payout ratio or a decrease in dividend. What this ultimately means is the impact of a recession on a dividend paying stock should be the same in total as the same stock all else equal without a dividend. Either the price of the two stocks would decline at the same rate, or the dividend stock would decline slightly less by an equivalent amount to their reduction in dividend. Either way the dividend stock has the same net impact on your assets during a recession as a non dividend stock, all else being equal.
This all being said, historically, dividend paying stocks have a tendency to be more established firms which tend to weather recessions better then other stock classes. This is why dividend stocks give off a perception of being less risky. However, over the long run they perform no differently then their large cap value peers.
Dividend Bearing Stocks are Currently Overpriced
At this point, people have been piling money into dividend stocks under the perception that they are safer. I theorize this means they are over priced in relation to the broader market when considered price to equity. Now, imagine when the next recession comes. If the dividend is cut, you may find yourself without the income you would otherwise require at the worst time. Meanwhile, the quality bond or quality bond fund, which usually is not correlated with the market, would continue to pay its fixed rate. Even if both decline given the lower risk bonds tend to carry the impact to bonds return will likely be less.
Ultimately what this means is you are likely better off not focusing your portfolio on dividend funds. If you feel the need to focus on a particular area, rather than index funds as I outlined earlier, dividend holdings are really not the best choice. A large cap value fund will likely provide you the same benefits as the dividend holdings with lower expenses ratios on the funds and more diversification.