Less Is More: Why I Prefer Low Yield Stocks

|
 |  Includes: BDX, C, DD, GE, GM, HD, HYG, JNK, JPM, MO, PFE, PM, SIAL, T, VZ, WMT
by: Difu Wu

Should investors looking for big dividends invest in high yield stocks or low yield stocks?

I used to prefer high yield stocks. My experiences, however, have taught me that the best long term returns come not from high yield stocks, but from low yield ones. I hope that, through this article, my readers will see why low yield stocks, in general, make better investments, without having to repeat the same mistakes I made investing in high yield stocks.

Here are five reasons why low yield stocks are actually better bets.

Reason #1: Safety

Safety should be of utmost importance in any investor's mind. Before worrying about return on investment, let us worry about return of investment. Bond investors know that the higher yielding bonds mean greater risk for default. Well, the same thing is true for common stocks.

Take a look at the list of 2008 "Dogs of Dow" (a list of 10 highest yielding stocks in the Dow Jones Industrial Average):

Symbol Company Price Yield Small Dog
NYSE / NASDAQ The Dow stocks ranked by yield on 12/31/07 on 12/31/07 on 12/31/07 on 12/31/07
C Citigroup 29.44 7.34% Yes
PFE Pfizer 22.73 5.63% Yes
GM General Motors 24.89 4.02% Yes
MO Altria
75.58 3.97% No
VZ Verizon 43.69 3.94% No
T AT&T 41.56 3.85% No
DD DuPont 44.09 3.72% No
JPM JP Morgan Chase 43.65 3.48% No
GE General Electric 37.07 3.35% Yes
HD Home Depot 26.94 3.34% Yes
Click to enlarge
from http://www.dogsofthedow.com/dogs2008.htm

Of the 10 Dogs of the Dow stocks in 2008, 5 of them proved that the high dividend was ephemeral. The highest yielding Dow stock from the 2008 list, Citigroup, offered a mouth-watering 7.34% yield. Unfortunately, it was not long before Citigroup had to suspend the dividend, and the stock fell to as low as $1 per share during the 2008-2009 financial crisis, a loss of more than 96 percent from the $29.44 price. At $34.23 today (02/08/12), after a reverse 1 for 10 split, Citigroup is still 88% off its price on 12/31/07. General Motors went bankrupt in 2009, ruling out any hope for a comeback. Pfizer had to cut its dividend by half in 2009 and its stock price plummeted. JP Morgan Chase had to cut its dividend rate from $1.44 to $0.20 in 2009 and its stock price plummeted. General Electric had to cut its dividend from $1.24 to $0.40 in 2009 and its stock price plummeted. Verizon and AT&T today are still below their prices on 12/31/07. Only Altria, DuPont, and Home Depot would have done well for their investors who held on till this day. Truly, without these three stocks, the 10 stock portfolio above would have done poorly.

High dividend yield is more risky for many reasons. First, it greatly reduces liquidity. More cash retained in the company helps to buffer the company from financial strains during economic recessions and depressions. Second, plant and equipment depreciate and money is required to update the company's depreciating assets, so a high dividend payout might compromise a company's needs to update its assets and remain competitive in its industry. Third, interesting investment opportunities may show up unexpectedly and favor the companies with adequate cash available to take advantage of them, so the company with little cash left after paying out a large dividend would miss these investment opportunities.

If high yield, blue chip Dow stocks cannot be relied upon for safety, how much less so for high yield stocks of lesser quality?

Reason #2: Growth

We invest in stocks, instead of bonds, to conserve purchasing power 10 or 20 years later and beyond. Investors who need high income now should invest in high yield bonds, such as JNK or HYG, instead. In a rapidly changing world, the best defense against inflation is a strong offense of high quality growth. Cash paid out as dividends are no longer available for reinvestment into the company to provide for future growth and expansion. That is bad. Paying out a large portion of earnings as dividends and forgoing future growth is analogous to the farmer who rushes his young calves and kids to sell in the market as soon as they are born, instead of waiting patiently to grow them up and allow them to fetch much higher prices in the future.

It is true, however, that companies that cannot reinvest their earnings successfully should pay them out as dividends, instead of wasting the cash. How can we discern the good companies that do well reinvesting earnings from the majority of companies that do not? The best way is by their track records. Companies that have done well reinvesting shareowners' money in the past 10 or 20 years or more are likely to continue doing a good job reinvesting earnings for future growth.

Take a look at the following chart.

click to enlarge

Click to enlarge

Over the past 18 years, both stocks provided excellent returns, but Becton-Dickinson (NYSE:BDX) generated a much better return than JP Morgan (NYSE:JPM). Adjusted for stock splits, Becton Dickinson paid $0.185 dividends from $0.7625 in earnings in 1994, a payout ratio of 0.24. BD's split-adjusted average stock price in 1994 was $9.4375, so the dividend yield was 1.96 percent. Adjusted for stock splits, JPM paid $0.55 dividends from $1.51 in earnings in 1994, a payout ratio of 0.36. JPM's split-adjusted average stock price in 1994 was $12.06, so the dividend yield was 4.6 percent, much higher than BD's 1.96 percent yield. JPM's payout ratio was also higher, which means less money is available for reinvestment. Throughout the last 18 years, BD's dividend yield and payout ratio have remained low, while JPM's have trended up and remained high. While there are many reasons for the performance difference, the difference in dividend yield and payout ratio might have played an important role.

Reason #3: Bigger Dividends

Not only do low yield stocks tend to provide better price appreciation than high yield stocks over the long term, they also tend to grow their dividends faster and pay bigger dividends in the end. Although still a low dividend yielder at 2.3 percent today, BD's dividend rate has now increased to $1.80. This is a 19 percent dividend yield on BD's split-adjusted average stock price of $9.4375 in 1994. In comparison, JPM's dividend rate has increased to $1, but this is only an 8 percent dividend yield on JPM's split-adjusted average stock price of $12.06 in 1994. So even though the current dividend yield of BD remains low, the actual dividend payout for investors who invested in BD in 1994 is now much bigger than for JPM's.

Reason #4: Taxes and Commissions

Dividends are subject to double taxation. Dividends come from net incomes after tax. After they are paid out to shareholders, the shareholders are taxed again. This makes cash dividends less valuable than cash retained in the business, which is why many companies are now choosing to return cash to shareholders in the form of share buybacks in addition to cash dividends.

Investors who save at least some of their cash dividends instead of spending them all must find new ways to reinvest this cash. After paying tax on the dividends and then commissions to reinvest the dividends, investors are reinvesting less money than they would have if the cash was simply retained in the companies instead of being paid out as dividends.

Reason #5: Time

In the end, nothing is more precious than time. Once it is gone, it is gone forever. Money automatically invested within the companies allow investors to grow their investments without any additional work. Money paid out as dividends, on the other hand, require investors to look for new ways to put the money to work. We invest mainly to become financially secure, so we have more time to tend to other aspects of our lives. Therefore, finding great companies that retain earnings and continue to put the money into good use for growth is priceless.

Conclusion

Investing is a marathon where the tortoise beats the hare. For reasons of safety, growth, bigger future dividends, taxes and commissions, and time, investors should favor low yield stocks with low payout ratio and a solid track record of increasing dividends and strong growth, such as Sigma-Aldrich (NASDAQ:SIAL), Becton Dickinson, and Wal-Mart (NYSE:WMT), for long term investments.

Disclosure: I am long BDX, WMT, T, JNK.