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Like everyone who leaves a cookie on any financial site, I am deluged by spam mail and push ads touting dividend stocks. There are a very large number of people trying to eke out a living by recommending dividend stocks. Permit me two observations:

1) The concept of dividend-stock investing is almost worthless, on the face of it; and

2) Dividend stocks did not offer much protection from the recent downdraft.

Why should an investor buy earnings in the form of dividends rather than capital gains stemming from future growth? The assumption would have to be that there are so few investment opportunities available that smart managers shouldn’t try to put capital to work, but should return the money to shareholders. But if that’s the case, why own equities to begin with? You are making the assumption at the outset that you own a declining business. You only make money this way if you assume that you can get money out at a high yield BEFORE the business declines too drastically. That’s why the dividend idea is not entirely dumb: rates of return on capital are quite low generally, and there are some opportunities to capture cash flow from businesses that aren’t declining, well, too quickly.

There are important exceptions. Some stocks are constructed to act like rather like bonds, for example utilities. They have sticky prices due to regulation (less downside in a recession) and–most importantly–they are hugely capital intensive, that is, they benefit from lower interest rates.

Utilities were the best performer from the late April market peak to the present.


(Click to enlarge)

The S&P SPDR’s are ranked by returns from April 29 to Sept. 22 in the table above. Also shown are the correlation of each sector with (respectively) a market risk factor (the first principal component in decomposition of returns across the universe) and correlation with the 10-year yield. Utilities had best performance because they have the lowest market exposure AND the highest correlation with interest rates (they benefit most when term yields fall).

The S&P Dividend SPDR falls about halfway down the table; without utilities, it would fall right in the middle. But the important thing to observe is that the Dividend SPDR has a 98% correlation with the Market Risk Factor, which is to say, it trades like the market.

Numbers aside, companies may pay a high dividend yield for a number of reasons. The simplest and most frequent is that the market simply doesn’t believe that they can continue to pay such high dividends. Every sector, and every issuer, is different, and investors need to do real research about the sources and uses of capital and the exposures they are willing to tolerate in different environments.

Source: The Dumb Dividend Idea