Are High Dividend Stocks a Good Investment?

As an investor in the accumulation stage, I tend to focus on companies with yields of at least 3% and expectations of future dividend growth. Most of these companies have a history of consistent annual dividend increases which exceeds ten years. I do receive constant criticism from readers however, that I profile very few stocks yielding 5%-6% or more; and when I do feature them I always express my negative opinion on the securities. I am not willing to accept an extremely high dividend payout ratio, which would have been acceptable for a utility or a Master Limited Partnership.

I do realize that most investors want to generate as much income as possible from their nest eggs, which have been accumulated over the spans of several decades’ worth of hard work and sacrifice. The problem with this approach is that investors end up focusing on the end result, without giving much thought about the sustainability and growth of the dividend payment. In other words, although it would take for a 3% yielder 7 years to double your original dividend payment and yield on cost, when the dividend growth is 10%, I believe that investors are better off in a sustainable lower yielder, than in an unsustainable high yielder. The company yielding 6% today that cuts its distributions a few months down the road could end up generating far less income than what you expected.

Some investors also disagree with me that stocks which are yielding 3% – 4% would barely produce enough income to keep up with inflation. The problem with this assumption is that in its goal of chasing the highest yielding stocks, you could end up losing from inflation. For example if you held all of your money in a group of stocks, yielding 8%-10%, and spending all the dividend income produced by your positions, you would lose purchasing power over time. Even worse – if the dividend payment is unsustainable, your yield on cost could even become lower than the current yield on S&P 500, if the company decides to cut distributions. Consider for example Bank of America (BAC), which at the beginning of 2008 would have yielded a cool 6.20%. Fast forward one year later, and the company is currently yielding 0.20%. The worst part is that the yield on your original investment in BAC is now 0.10%.

Compare this to Kimberly-Clark (KMB), which yielded about 3% at the beginning of 2008 but which has raised distributions twice, for a total dividend growth of 13.21%. Your yield on cost is almost 3.5% now, and that is without taking into effect any dividend reinvestment.

A common issue among high yielders is that they have a high dividend payout ratio. This means that the company is paying most of its earnings out as dividends, and doesn’t leave much for reinvestment in the business. If you add in stagnant earnings per share growth, and you basically have a disaster in the making. If that company all of a sudden decides that it needs cash for anything like merger or acquisition or if its earnings drop due to an economic contraction, chances are very high that the dividend payment, which was unsustainable in the first place, would be the first on the management’s chopping block.

Consider Pfizer (PFE) for example. The company spotted a very high payout ratio both in 2007 and 2008. Investors who purchased the stock hoping that this cash rich drug giant would pay a 6%-7% were terribly disappointed when on January 26th Pfizer cut its dividend. The move helped the company save billions, which were much necessary for its acquisition of Wyeth (WYE).

I do realize however that dividend growth is not guaranteed as well. But then I have a requirement of an initial minimum yield of 3% as a margin of safety in case this happens. Chances of a dividend cut are much larger for a company with a current yield of 6%, than for a company yielding 3%. The market is efficient in this section, so you have to understand what risk the high yielders represent, before leaping into the unknown.

Just for the sake of comparison, I identified the components of the dividend aristocrat’s index, which currently yield more than 4%. Of the eleven companies presented, only Kimberly-Clark and Cincinnati Financial (CINF) had what somewhat sustainable dividend payouts.

Disclosure: Long CINF and KMB

Comments

[DavidReid1980:]

While it is indeed a good idea to watch out for very high dividend yields, to say the chance that a 6% yield will be cut is higher than the chance that a 3% yield will be cut doesn't seem to make much sense to me.

Sep 16 10:49 AM

[techsport:]

I also think that the Payout ra

Sep 16 03:22 PM

[jjp:]

I am very fond of the telecoms and I believe their dividends are sustainable and they are extremely safe. The biggest problem I have had is that some of the foreign ones have had their stock increase in value to the point that I cash them in at sign of a pull back since that gain is greater than the amount of the dividend. I certainly have more faith in ATT than Kimberly Clark in this economy. When things are bad, you talk more on the phone, not less. :)

Sep 16 06:29 PM

[THofler:]

I'd love to read more about how the author gages dividend sustainability. I should think it is more than just looking at payout ratios. Some have said they prefer div. payout to cashflow ratios to the usual ratio.

Also, the non-cyclical level of revenue and cashflow stability, as well as the plain old growth levels should matter a great deal. For example, a 90% payout ratio should be very sustainable if the company is moderately non-cyclical and is growing relatively quickly.

Sep 16 10:17 PM

[YoYoMama:]

I am one of those who Dividend Growth Investor refers to. I won't touch a yield less than 5%.

I also know that Dividend Growth Investor has money to put into his portfolio. I do not.

The nest egg IRA I have comes from me and my husband, back when we worked for Fortune 100 companies and had generous 401K plans, which we collectively built into 6 figures.

However, eight years ago, in order to take care of three children (one of which was special needs), we quit the corporate world to form our own company. While we are now profitable, for many years we were not, and still, even today do not have the disposable income to plow into the IRA.

So - what to do? I could consider going Dividend Growth Investors way. However, his recommendations, typically, are stodgy growers with little dividend for reward. While this will work for those who can grown their portfolio by continually placing money into the plan, for me - someone who has no money to contribute - it will not work. I have done the calculations, and I will not reach my goal of 7 figures his way.

So I am forced to consider capital appreciation (where I can take profits as needed) and dividend yield (which grows the portfolio quicker) - in combination - in order to reach retirement. Therefore, yield is critical, it must be high, and the stock/bond must have the potential for capital appreciation.

For this reason, I believe Dividend Growth Investor should not have the only viewpoint. However, if you do have money to put into your brokerage or IRA, certainly his way is a certain (but slow) path to income growth.

Sep 17 09:20 AM

[David Van K...:]

On dividend sustainability: I examine each company's financial situation individually, along with its history and culture of sustainiing and growing its dividend. The payout ratio is just one metric, and not the most important one, in my opinion.

I believe that each company has a "natural" level of dividend distribution--one that works for its business model, in its industry, etc. Dividends are just one of hundreds of things that companies can do with their profits. Each company picks and chooses from among available options. Over time, they settle into nearly predictable patterns. That's why examining the history and culture of dividend increases is important.

That said, a company cannot pay dividends if it doesn't have the money, at least not for long (for a year or two, it can act like a bank and pay dividends via borrowed money, but that is not sustainable). So examining the company's financial situation is important. Where is the money? Look for strong cash flow, growing profits, a sustainable business model, etc. Get your fingers dirty. Most dividend cuts are predictable.

Sep 17 11:03 AM

[DavidReid1980:]

I totally agree with you David, examining a company's financial situation before investing in it is very important. Don't just look at those huge dividend yields. Indeed, most cuts are predictable.

Some companies just can sustain a high dividend yield, accept it and use it I say!

Sep 17 11:45 AM

[GimliJan:]

I like all of the information and comments in this article. I also don't have the long time frame needed to invest my entire portfolio in 2-4% Large Cap Dividend Companies. I am doing well to invest $100-$200 a month. At 55 years old and starting over after filing a chapter 7 bankruptcy (medical debt, spouse long term illness and 3 special needs kids) I have to balance my Microsoft, Intel and BP with MLP's and some Small and Mid Cap's with good growth potential. I do agree that every retirement portfolio should have a core of holdings that meet the criteria of a sustainable dividend as recommended by Dividend Growth Investor, David and other writers here.

Sep 17 12:43 PM

[David Van K...:]

YoYo and Gimli,

Your situations are interesting and challenging. You each appear to have about a 10-year timeframe to get to a nest egg of a certain size, say $1M just for discussion.

YoYo says she has done the math, and can't get there from where she is with stocks that start at (say) 3%-4% yield and grow their dividends (say) 10% per year. There's no disputing the math, if it doesn't work, it doesn't work.

DGI's (and my) dividend investment strategies are predicated on growing the dividend investment stream over time. But our life situations are totally different. He is, I will guess, in his thirties and has 20-30 years to grow that stream to where he wants it. I am 63 and retired. I have no new money to put into my accounts either. So why do we have such similar strategies?

My guess is that we are both almost totally focused on the dividend stream rather than on the size of the nest egg. Speaking for myself, I am coming to the conclusion that in retirement, your income stream is what matters the most--not the size of the nest egg. The value of dividend stocks to me lies not in what I could sell them for, but rather in their ability to spin out ever-growing dividend (income) streams. I won't go so far as to say the size of the nest egg is irrelevant, but it matters way less than the size of the dividend stream.

Here's just a suggestion, based on how I approach things: Maintain two portfolios. Focus one on capital appreciation. Its job is to grow. There may be no dividend stocks in it. You'll have to figure out your risk tolerance...there's no escaping that "growth" stocks sometimes shrink instead. Protect yourself on the downside (I use trailing stops, the least sophisticated but perhaps most effective form of hedging). Don't be afraid to be in cash when the markets are working against you...Job 1 is to not lose.

Focus the other portfolio on dividend growth. I demand a 3% initial yield, YoYo says she demands 5%. The goal in this portfolio is not growth of capital, rather it's growth of the dividend stream. That dividend stream should almost never shrink from year to year, it should always grow. Try to improve that portfolio each year, but generally, if you choose your stocks right, you won't trade much in this portfolio. Reinvest the dividends to accelerate the growth of the dividend stream (you may find yourself hoping for price drops so you can buy more shares = buy more dividends). If you do your research carefully, stocks in this portfolio will almost never cut their dividend...maybe 1-2 surprises a year is all, and if they do, replace them. Don't go to cash...keep your eye on the dividend stream's growth, not the prices of the stocks.

It goes without saying, but I'll say it, that I'm only talking here about the stock portion of your total wealth. I'm assuming that you've already laid out an asset-allocation strategy as between stocks, bonds, and cash.

Best of luck!!

Sep 17 01:29 PM

[Michael Con...:]

Two points:
1. the long term IRR on a dividend paying stock is equal to the current yield + the dividend growth rate. This formula should always be included in any long term investment;
2. comparing the dividend payout ratio using net income is useless and misleading. Use instead cash flow per share. Net income is NOT cash. The single most important number to look at in any company, public or private, is "cash flow from continuing operations".

Sep 17 02:21 PM

[mbkelly75:]

Dividends4Life pointed out in another article today that:
Free Cash Flow + Debt to Total Capital < 100%
This would make sure that they have enough cash to pay out that dividend - whatever their payout ratio is.

David - You are exactly right and it was well said. I maintain 2 portfolios for about that same reason:
1) Exploration Portfolio: for dividend and non-dividend stocks that look really good to me and are worth having if only for a trading period. These stocks are protected by a trailing stop-loss in case I am wrong about them. This portfolio also holds Bond ETFs, MLPs, CANROYs, and REITs. Dividends and Interest Payments are re-invested if not needed for an emergency bill.
2) Core Portfolio: Basically only for Long-Term holdings of dividend stocks that have paid a RISING dividend for a minimum of 5 years - preferably 10 or more. These dividends are re-invested as they come in and are intended to be held for at least 7 to 10 years - preferably for my lifetime. (I have held a couple for 50 years now.)
I keep track of my cost-basis and do not put extra money into a stock that is priced higher than my cost-basis EXCEPT for dividend re-investment. If the stock drops below my cost-basis - then I very likely will put extra cash into it. I LOVE a bear market for this purpose.

Sep 17 04:01 PM

[YoYoMama:]

David -

You will be happy to know that I follow your plan!! I maintain a separate brokerage account from my IRA that follows a strict dividend strategy.

My focus in the brokerage, however, is tax-free income. Every month I put in $100 (that's all I can afford at this time) and purchase a tax-free CEF yielding 5% or more after expenses.

The CEF must be under NAV, and must have a track record of increasing dividends. There are a surprising number of great choices out there that qualify. The yield equates to the taxable equivalent of 8% or less.

So, I am following dual strategies. Any new monies are going into tax-free in the brokerage. The "nest egg" IRA will follow a growth strategy using a combination of capital appreciation and higher yield dividends. With the goal of 7 figures between the two, and minimum yield between the two strategies of 5% (partially tax-advantaged), my husband and I should reach a nice retirement.

On Sep 17 01:29 PM David Van Knapp wrote:

> YoYo and Gimli,
>

> Here's just a suggestion, based on how I approach things: Maintain
> two portfolios. Focus one on capital appreciation. Its job is to
> grow. There may be no dividend stocks in it. You'll have to figure
> out your risk tolerance...there's no escaping that "growth" stocks
> sometimes shrink instead. Protect yourself on the downside (I use
> trailing stops, the least sophisticated but perhaps most effective
> form of hedging). Don't be afraid to be in cash when the markets
> are working against you...Job 1 is to not lose.
>
> Focus the other portfolio on dividend growth. I demand a 3% initial
> yield, YoYo says she demands 5%. The goal in this portfolio is not
> growth of capital, rather it's growth of the dividend stream. That
> dividend stream should almost never shrink from year to year, it
> should always grow.

Sep 18 09:14 AM

[YoYoMama:]

"The yield equates to the taxable equivalent of 8% or less...."

OOPS. I should have said 8% or more.

Sep 18 09:15 AM

[Tack:]

The best plan of all is to look for depressed preferred shares in companies that also pay common dividends and will maintain them at some level above zero. Because no common dividends can be paid, at all, until every penny of preferred dividends is paid in full, if one is assured that some level of common dividends --even a penny-- will be paid, then, one can rest assured of receiving 100% of the preferred dividend due.

This strategy works particularly well with REITs and BDC's because they are required to pay out 90% of current earnings in common dividends, virtually assuring that preferred dividends are paid, as long as the company makes a single dime of common-share earnings.

Sep 18 11:22 AM

[harris m fr...:]

when i purchased these 5 years ago they were all
paying over 12% pwe, bte, pvx, pgh, hte. i only
buy stocks that pay over 10% i also buy closed
end funds that pay over 12%

Sep 20 09:23 PM

[GimliJan:]

David,
Thank you for the reply and the good investment advice. I am currently holding all of my stocks, mlp's in a Roth IRA discount trading account. I also have my 401k allocated to bonds. The current allocation Bonds to Stocks is 66%. I plan on setting up a separate regular trading account specifically for high growth/high risk stocks (penny/microcap) and allocate 20% of my total investment in it.
I also ran some numbers using retirement calculators using 15 year timeframe and the results were very ugly!
Question: When I have to rollover my 401k into an IRA, would it be better to just roll all of it into my Roth IRA trading account? or shift a 20% stake into the new trading account for the high growth/risk portfolio? I will be shifting the majority of it to high grade corporate bonds with decent yields (4-6%) but need to jump start the other portfolio.

Thanks,
Gimli


On Sep 17 01:29 PM David Van Knapp wrote:

> YoYo and Gimli,
>
> Your situations are interesting and challenging. You each appear
> to have about a 10-year timeframe to get to a nest egg of a certain
> size, say $1M just for discussion.
>
> YoYo says she has done the math, and can't get there from where she
> is with stocks that start at (say) 3%-4% yield and grow their dividends
> (say) 10% per year. There's no disputing the math, if it doesn't
> work, it doesn't work.
>
> DGI's (and my) dividend investment strategies are predicated on growing
> the dividend investment stream over time. But our life situations
> are totally different. He is, I will guess, in his thirties and has
> 20-30 years to grow that stream to where he wants it. I am 63 and
> retired. I have no new money to put into my accounts either. So why
> do we have such similar strategies?
>
> My guess is that we are both almost totally focused on the dividend
> stream rather than on the size of the nest egg. Speaking for myself,
> I am coming to the conclusion that in retirement, your income stream
> is what matters the most--not the size of the nest egg. The value
> of dividend stocks to me lies not in what I could sell them for,
> but rather in their ability to spin out ever-growing dividend (income)
> streams. I won't go so far as to say the size of the nest egg is
> irrelevant, but it matters way less than the size of the dividend
> stream.
>
> Here's just a suggestion, based on how I approach things: Maintain
> two portfolios. Focus one on capital appreciation. Its job is to
> grow. There may be no dividend stocks in it. You'll have to figure
> out your risk tolerance...there's no escaping that "growth" stocks
> sometimes shrink instead. Protect yourself on the downside (I use
> trailing stops, the least sophisticated but perhaps most effective
> form of hedging). Don't be afraid to be in cash when the markets
> are working against you...Job 1 is to not lose.
>
> Focus the other portfolio on dividend growth. I demand a 3% initial
> yield, YoYo says she demands 5%. The goal in this portfolio is not
> growth of capital, rather it's growth of the dividend stream. That
> dividend stream should almost never shrink from year to year, it
> should always grow. Try to improve that portfolio each year, but
> generally, if you choose your stocks right, you won't trade much
> in this portfolio. Reinvest the dividends to accelerate the growth
> of the dividend stream (you may find yourself hoping for price drops
> so you can buy more shares = buy more dividends). If you do your
> research carefully, stocks in this portfolio will almost never cut
> their dividend...maybe 1-2 surprises a year is all, and if they do,
> replace them. Don't go to cash...keep your eye on the dividend stream's
> growth, not the prices of the stocks.
>
> It goes without saying, but I'll say it, that I'm only talking here
> about the stock portion of your total wealth. I'm assuming that you've
> already laid out an asset-allocation strategy as between stocks,
> bonds, and cash.
>
> Best of luck!!

Oct 19 09:43 AM