There's no free lunch, as they say, and that holds true in investing. At least most of the time. If there is anything close to a free lunch in investing, it might be the dividend. In 2011, investors embraced the dividend en masse. Stocks that were once unheralded, like Eli Lilly (NYSE:LLY), were acting like some of the most exciting names.
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Hold on, Eli Lilly? If you're a student of the stock market, you know that Eli Lilly is hardly considered a growth stock. Since the 2008 and 2009 recession, Eli Lilly has hovered around $35 per share, but the approximate 4% dividend has kept investors in a stock that showed little capital appreciation for years.
All of that changed in the middle of 2011, when investors began pouring into dividend stocks like Eli Lilly. What is a dividend stock, why did investors suddenly fall in love with these less-than-exciting names and will the trend continue in 2012? (For related reading, see Why Dividends Matter.)
What's a Dividend?
Big companies have a problem and that problem is that they're big. As a general rule, a big company can't grow as easily as a smaller company, and at some point, it becomes extremely difficult for companies like Walmart (NYSE:WMT) to grow at a rate that translates to big gains in their stock price.
In order to attract investors, these large corporations directly pay shareholders a portion of their earnings to make up for the lack of growth in their stock. This dividend is normally paid quarterly and is declared by the company each quarter, as a fixed amount per share. Because it's a fixed price, when the stock price goes up, the value or yield of the dividend goes down. When the share price falls, the yield rises.
What's Different Now?
Dividend stocks like Eli Lilly have seen gains of about 11% since October, and Kraft (NYSE:KFT) has seen an impressive gain of around 14%, easily outpacing popular growth stocks like Amazon (Nasdaq:AMZN), which is down around 16% over the same time frame. The SPDR S&P Dividend ETF (ARCA:SDY), the Exchange-Traded Fund (ETF) that tracks dividend stocks, beat the S&P 500 ETF (ARCA:SPY) by more than 3% over the past year. What changed to make dividend stocks so attractive?
Investors have differing opinions, but a prevailing reason is Europe. As Europe has destabilized, worries of catastrophic effects on North American markets have caused investors to buy up safe-haven stocks that have a stable dividend. With 2008 and 2009 still fresh in their minds, and in a market that sees violent swings in both directions from day to day, keeping money safe is more important than making money.
Will This Continue?
With continued fears in Europe, along with highly volatile markets in the United States, dividend stocks may continue to grow in popularity. However, before jumping into these names, remember that while they will likely reclaim their role as safe-haven stocks, it won't be until after a potentially painful correction for investors who were late to buy these names. Because these stocks are functioning more like the volatile growth stocks in the market, they may lose any market weakness to reclaim their role as safe-haven names. (To learn more, read Volatility's Impact On Market Returns.)
The Bottom Line
Names like Eli Lilly and Kraft not only pay a healthy dividend, but in the second half of 2011 they also awarded shareholders with capital growth. Right now, the prices of these stocks are high, which makes the dividend yield much lower. Be patient if a name you like has seen a large rise in price. There will likely be a better time to buy in the not-so-distant future. (To learn how to calculate dividend yield, read Investment Valuation Ratios: Dividend Yield.)
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At the time of writing, Tim Parker did not own shares in any of the companies mentioned in this article.