One of the first things most new investors learn is that dividend stocks are a wise option. Generally thought of as a safer option than growth stocks—or other stocks that don't pay a dividend—dividend stocks occupy a few spots in even the most novice investors' portfolios. Yet, dividend stocks aren't all the sleepy, safe options we've been led to believe. Like all investments, dividend stocks come in all shapes and colors, and it is important to not paint them with a broad brushstroke.
Here are the three biggest misconceptions about dividend stocks. Understanding them should help you choose better dividend stocks.
- Many investors look to dividend-paying stocks to generate income in addition to capital gains.
- A high dividend yield, however, may not always be a good sign, since the company is returning so much of its profits to investors (rather than growing the company.)
- The dividend yield, in conjunction with total return, can be a top factor as dividends are often counted on to improve the total return of an investment.
High Yield is Best
The biggest misconception of dividend stocks is that a high yield is always a good thing. Many dividend investors simply choose a collection of the highest dividend-paying stock and hope for the best. For a number of reasons, this is not always a good idea.
Remember, a dividend is a percentage of a business’s profits that it is paying to its owners (shareholders) in the form of cash also quoted as its payout ratio. Any money that is paid out in a dividend is not reinvested in the business. If a business is paying shareholders too high a percentage of its profits, it may be a sign that management prefers not to reinvest in the company given the lack of upside. Therefore, the dividend payout ratio, which measures the percentage of profits a company pays out to shareholders, is a key metric to watch because it is a sign that a dividend payer still has the flexibility to reinvest and grow its business.
Some sectors of the market have a standard for high payouts and its also part of the sector’s corporate structure. Real estate investment trusts (REIT) and master limited partnership (MLP) are two examples. These companies have high payout ratios and high dividend yield because it is ingrained in their structure.
5 Common Misconceptions About Dividends
Dividend Stocks are Always Boring
Naturally, when it comes to high dividend payers most of us think of utility companies and other slow-growth businesses. These businesses come to mind first because investors too often focus on the highest-yielding stocks. If you lower the importance of yield, dividend stocks can become much more exciting.
Some of the best traits a dividend stock can have are the announcement of a new dividend, high dividend growth metrics over recent years, or the potential to commit more and raise the dividend (even if the current yield is low). Any of these announcements can be a very exciting development that can jolt the stock price and result in a greater total return. Sure, trying to predict management’s dividends and whether a dividend stock will go up in the future is not easy, but there are several indicators.
- Financial flexibility: If a stock has a low dividend payout ratio but it is generating high levels of free cash flow, it obviously has room to increase its dividend. Low CapEx and debt levels are also ideal. On the other hand, if a company is taking out debt to maintain its dividend, that is not a good sign.
- Organic growth: Earnings growth is one indicator but also keep an eye on cash flow and revenues as well. If a company is growing organically (i.e. increased foot traffic, sales, margins), then it may only be a matter of time before the dividend is increased. However, if a company’s growth is coming from high-risk investments or international expansion then a dividend could be less certain.
Dividend Stocks are Always Safe
Dividend stocks are known for being safe, reliable investments. Many of them are top value companies. The dividend aristocrats—companies that have increased their dividend annually over the past 25 years—are often considered safe companies. When you look at the S&P 100, which provides a list of the largest and most established companies in the U.S., you will also find an abundance of safe and growing dividend payers.
However, just because a company is producing dividends doesn’t always make it a safe bet. Management can use the dividend to placate frustrated investors when the stock isn't moving. (In fact, many companies have been known to do this.) Therefore, to avoid dividend traps, it's always important to at least consider how management is using the dividend in its corporate strategy. Dividends that are consolation prizes to investors for a lack of growth are almost always bad ideas. In 2008, the dividend yields of many stocks were pushed artificially high due to stock price declines. For a moment, those dividend yields looked tempting. But as the financial crises deepened, and profits plunged, many dividend programs were cut altogether. A sudden cut to a dividend program often sends stock shares tumbling, as was the case with so many bank stocks in 2008.
The Bottom Line
Ultimately, investors are best served by looking beyond the dividend yield at a few key factors that can help to influence their investing decisions. The dividend yield, in conjunction with total return, can be a top factor as dividends are often counted on to improve the total return of an investment. Looking only to safe dividend payers can also significantly narrow the universe of dividend investments.
Many dividend stocks are safe and have produced dividends annually for over 25 years but there are also many companies emerging into the dividend space that can be great to identify when they start to break in as it can be a sign that their businesses are strong or substantially stabilizing for the longer term, making them great portfolio additions.