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The equity strategy that I have run for the last 13-plus years always has a slightly higher yield than the S&P 500. But I never look for dividends. It's not a factor in my process. That said, looking for businesses that produce free cash flow, and voila, the dividends appear.

At present, with interest rates so low, many people look at dividend-paying common stocks as a means of obtaining income. They also add REITs, MLPs, BDCs and an assortment of other things that trade like stocks and have yield. I don't think this is a safe way to get yield, at least not now. Here's why:

1) Think of the 1970s, when I was a teenager. Not only were interest rates higher, and inflation eating away at purchasing power, but when companies got into trouble, they would cut their dividends, and often severely. During that era, you had to make sure that the company was actually earning the dividend, or were they borrowing to pay it?

2) There have been many flameouts in REITs, especially mortgage REITs. I remember buying broken mortgage REITs in the mid-90s at less than half of their net worth after they had bought exotic CMO pieces, trying to create funds where the value rose as interest rates moved higher. They got crushed in the early 90s by Greenspan's hyper-easy monetary policy. In 1994, as rates were rising, they rallied significantly.

Mortgage REITs also were crushed in 2008-9. But Equity REITs have their times of trouble as well - they tend to be bull market babies. When commercial real estate is doing well, they do extra well. When it goes badly, it goes extra badly for the REITs because of all the leverage.

3) I mentioned 1994. In 1994, as rates rose, dividend paying stocks underperformed. The value manager that Provident Mutual used at that time was an absolute yield manager. In other words, that manager only bought stocks that had a yield higher than a fixed threshold. At that point, the threshold was 4% or so. From 1982 to 1993, as interest rates fell, this manager was golden, but it was an artifact of the era. In 1994, the performance was abysmal. The manager was replaced the next year.

High yielding stocks paying out a large portion of their earnings as dividends tend to have their dividends grow slowly because there is little left over to reinvest into new business. It is akin to owning a bond disguised as a stock. Lower-yielding stocks often grow their dividends more rapidly, as they reinvest more free cash into new business. With Equity REITs, the latter strategy has generally been more successful. Better to buy the lower yielding REITs that grow their dividends faster.

4) The REITs, MLPs and BDCs that pay out a a high proportion of their taxable income are weak vehicles because they are forced to pay out so much. During crises, that really bites them.

(This wasn't as short as I thought it would be. Oh well.)

Conclusion

If interest rates rise, and I do mean if, because the economy is weak, be ready to see these modern income vehicles take a hit. If we have a severe recession, be aware that dividends do get cut. Do not rely on stocks for income. Bonds are designed for income and return of principal. Stocks are designed for gains or losses depending upon the underlying business performance. They aren't income vehicles, but performance vehicles.

Disclosure: None.

Source: A Brief Note On Dividend-Paying Common Stocks