'Buying Dividend Stocks For Income' Arguments Don't Make Sense

by: Lawrence Weinman

I’ve been poking around Seeking Alpha‘s "Investing for Income" section and have read some of the thoughts of those who are fixated on dividend yield as a way to generate income and build their portfolios. I find their logic a bit slippery.

The argument seems to go like this: When the stock market drops, screen for stocks that have a high dividend. Particularly attractive are those with dividends north of 4%. If the market falls further, buy more of such stocks, locking in a higher dividend. Don’t pay attention to the diminished value of your equity holdings. Why buy more? Either because you “never" plan on selling the stock or because the stocks will always come back because these are stocks of good solid companies. In fact, many of these companies will likely increase their dividend as their earnings grow, making you a double winner.

I can’t fault these people for their optimism but I do find their logic somewhat lacking. First off, they seem to be confusing analysis with arithmetic. If a stock price falls and there is no change in the dividend, the dividend yield goes up. It's simple arithmetic; the dividend payout is the numerator and the stock price is the denominator.

If the market is consistently wrong on the future aspects of the company, the increase in the yield may indicate a buying opportunity. But even if the change in stock price is totally random, the increase in the yield doesn’t indicate the attractiveness of the stock. If the market is random on a day to day basis it's just as likely that the stock will fall further, presenting an opportunity to buy the stock at a more attractive yield/price.

Saying an increase in the stock's yield is a buy signal is no different than saying that a fall in price is a buy signal. Sometimes it is and sometimes it isn’t. I don’t have much faith in market timing or stock picking.

Also, maybe there is some information in that lower stock price as to the company, industry or economy’s future. Perhaps there is anticipation of an environment that would produce lower future earnings. And that of course could lead to a cut in dividends. In fact, that fall in the stock price could mean the prospects of a future with both a lower stock price and a dividend cut, meaning both the price and the dividend yield could fall. In any case, simply declaring that buying stocks with high dividends is a winning formula doesn’t seem logical to me.

Value investors who look at indicators such as p/e or p/b (both a similar function of numerator and denominator, with the price being the denominator) are not unaware of the danger of the value trap. Their indicator of "value" (low p/e or p/b) may also indicate the fundamentals of the company have deteriorated. They acknowledge that the markets are not totally irrational and that the folks selling that stock may know something. The stock could be "cheap" for a good reason. And that "cheap stock" may get even cheaper because the price will go lower.

From what I've read, it seems many of the investors for income are unaware of the possibility of a dividend trap--that high yielding dividend stock may have a high dividend (low price) for a reason. And that yield may go up (price down) even further. And that may be because of poor earnings prospects, which could even at some point lead to a dividend cut. The market may not always be wrong in its pricing.

It also strikes me as strange to advocate a dividend stock for income strategy in the current economic environment. Certainly the message of the stock and bond market is that a second dip of the recession is likely, if we're not already in one. Recessions mean lower earnings and dividends eventually have to come out of earnings. And companies can cut dividends. But it seems that in the world of the dividend for income school of investing only two things happen to companies with high dividend yield: They keep paying the same dividend or they raise the dividend.

In the current environment when dividends are often being paid out of cash raised from bonds rather than from increasing earnings the possibility is particularly high that dividends could be cut in the future.

Next comes the “total return” doesn’t matter refrain. If the stock falls further, it’s just an opportunity to buy more shares of this company at a higher yield. 'I don’t care about the stock price,' the dividend buyer declares; 'I plan to hold the stock forever and collect the dividends and this company has a record of increasing dividends.'

I don’t get the economics here. I can’t understand how any rational investor wouldn’t rather have a stock that doubles in price and pays no dividend than one that pays a dividend and drops in value. I can always sell some of the appreciated stock for real money if I need the cash (and possibly pay a low capital gains rate).

If the value of the stock falls, that’s an economic event and even if I buy more stock at a “higher yield” it doesn’t change the cash flow from the dividends of my depreciated stock. The stock on the shares I previously bought for $100 are paying a $4 dividend, the fact that I bought some more shares for $50 at a yield of 8% hasn’t exactly improved my economic situation. And of course I’ve increased my risk by buying more of those shares. Reducing the “average yield” on my stock holdings hasn’t reduced my risk any more than reducing my “average cost” by buying more shares of a stock after the price has dropped. And as I noted above of course maybe, just maybe, that falling stock is a function of some kind of economic distress for the company which might lead it to cut its dividend.

Finally there is the confusion about risk and diversification. As seen in the graph below of the correlation between the DLN large cap high dividend ETF and the SPY S&P 500, dividend stocks have a near perfect correlation to the overall stock market.

[Click to enlarge]
Click to enlarge

Even if a portfolio of high dividend stocks would outperform a different stock portfolio it still has virtually all the same market risk of any other stock portfolio. Dividend stocks only “always come back” if the overall stock market does so. And a declining price (which means a higher yield for a dividend payer) is not always an indication of a buying opportunity.

Buying high dividend stocks is a stock buying strategy not an income strategy. Using high dividends as a screen to buy stocks is simply using lower price (the denominator of the dividend yield calculation) as an indicator of a bargain. A portfolio of dividend stocks will have the same risk/reward characteristics of other equity portfolios. And that stable income anticipated from dividends can be changed at any time by the equity issuer if the company’s cash flow and/or earnings situation deteriorates. When is it most likely that the dividend will be cut....after the stock has fallen due to poor earnings prospects. In other words, just after you bought more shares because the dividend yield went up (price down=yield up).

Stocks go down in recessions and dividends are cut during recessions. On the other hand, interest rates fall when economic times get worse and bond prices go up. Reading between the lines, it seems that these dividend investors are looking for the following:

  • Cash flow from their investments.
  • Opportunity for capital appreciation in a rising stock market.
  • Less risk than the overall stock market.
  • High yield.
  • Some diversification from the risk of the overall stock market.

The problem is in looking at high dividend stocks they are looking in the wrong place. There is an asset class that fits the above criteria better than high dividend equities. It is high yield bonds.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.