Investors who purchase dividend paying stocks usually are looking to generate a stream of income from their investments. Yes, there are exceptions to the rule, for instance, when Apple (AAPL) starts paying a dividend next quarter, where most investors are still concerned about growth. More about that later.
But for the most part, that stream of income provides a couple of benefits. First, investors get something back from the company, even if the stock goes nowhere. That payment can be pocketed by the investor, used to purchase additional shares, or maybe used to purchase some other stock. Dividends also provide some safety, because they can lessen your losses when a stock declines over time. Generally speaking, dividend paying stocks are considered "safer" investments amongst the investment community.
However, there is a common misconception out there that I will discuss today. A lot of times, I hear investors saying how a stock is better because the dividend yield has increased. But those investors fail to mention why that yield has increased. If the yield increased because the company increased its dividend, that's good. If the yield has increased only because the stock price went down, that's bad.
Before I get into the main argument, just look at recent events involving SuperValu (SVU). When the company reported a terrible quarter, it announced that the dividend was being suspended. The dividend yield on this stock kept rising as the stock fell from $9 to $5. In fact, it had become a high-yield favorite among some. Prior to that earnings release, the yield stood at 6.6%, and it had been higher as the stock was lower in the weeks prior. But once the report came out, the yield was 0%. Yes, dividends can be wiped away, just like that. Just because a yield is high, doesn't mean a company can't eliminate the dividend, or lower it. Sometimes, high dividends are a red flag.
But to illustrate my main point today, let's look at one of my dividend favorites, Microsoft (MSFT). Over the past couple of years, the company has increased its quarterly dividend from 11 cents to 13, then 16, and now it is at 20. The company will most likely announce another raise later this year, something I recently discussed. Microsoft fits in the category of "things are good" when the yield is rising, because it usually means that the company has increased the dividend.
However, a common mistake is made when investors think that yields increasing can be a good thing, when a dividend is constant. For this example, let's assume that you bought 100 shares of Microsoft at $32. At this price, the annual yield is 2.50%, as we are using the current 20 cent per quarter dividend. Since you own 100 shares, you get $20 per quarter, or $80 per year. Simple enough.
Now, let's say the stock declines to $30. You still own 100 shares. The yield is now 2.67%. An investor might think this is good. Investors are getting an extra 17 basis points on their investment (per year). But are they really getting more? The answer really is no. They are still getting the same $20 per quarter, or $80 per year. The only difference is that based on the current price they are getting more, not on the price they bought it at. Oh, one other thing to mention. Since the stock is now at $30, and the investors bought at $32, they have now lost $200 on their investment, assuming no dividends were paid in that time period. So tell me how a higher yield is a good thing?
The following table really illustrates how this all works:
If the stock falls to $28 now, the current yield is higher, but now you are $400 in the hole before dividends. Hardly something to celebrate, and again, you're still getting paid the same $80 per year.
Now, for an investor who was looking at the stock at $32, but held back on the purchase until $30, the rising yield does look more attractive. But what does that do for investors who have held the stock for a $2 loss? Absolutely nothing.
Now, you can make the case that as the stock falls and the yield increases, you can buy more stock at a cheaper price. Sure, you could, although be careful. One of my fellow contributors on this site recently illustrated how averaging down can be a bad idea. Dr. Kris shows how when a stock is falling, averaging down can lose you even more money.
Think about that logically. You buy 100 shares of Microsoft at $32. For every dollar it falls, you buy another 100 shares because the yield is increasing. You buy all the way down to $28. Well, you now have 500 shares of Microsoft at $28, and your average cost is $30. The good news is that now you are going to receive $100 per quarter, or $400 per year. Your current yield is now 2.86%, but the yield on your shares purchased is just 2.67% (since your average price is $30). It might look good that you've averaged your cost basis from $32 to $30, and that you'll receive an extra $80 per quarter or $320 per year. But at this point, you have lost $1,000. That's only with a few hundred shares, imagine what happens if you have several thousand shares.
Now, you may laugh at me and say that Microsoft isn't going to drop $4 that quickly, and that you'll make up some of that money with the dividends being paid. But from April 20 to June 1, Microsoft did fall more than $4. That is less than a month and a half. While Microsoft did in fact pay a dividend in that period, what if the fall from $32 to $28 was in a different six-week period? There is a pretty good chance that over a six-week period, when it comes to any stock, you may not receive any dividends, so that $1,000 loss is a $1,000 loss.
Now sure, I could have used a number of different names to illustrate my point. But I chose Microsoft because it is a dividend name I follow closely, and one I have written about extensively. Now, I don't want anyone to think I am portraying a negative picture here for Microsoft. In fact, it's just the opposite. Microsoft is one of my dividend favorites. I named it as one of my top value picks for 2012. The company is paying a very solid dividend, which is expected to be increased later this year. The company is also increasing its very large cash hoard, which will allow it to not only raise those dividends, but continue buying back billions of dollars worth of its own stock.
Now along these same lines, there is an important point to be made with Apple as well. The same theory that applies to Microsoft that can be applied to Apple. If you buy shares at $600 and it falls to $550, the current yield is higher, but you've lost $50. Remember that.
As everyone hopefully now knows, Apple announced in March that it would start paying a dividend again (yes, it used to pay dividends). But it also said that payments would not start until its fiscal 4th quarter, which runs from July through September. So in fact, the first dividend payment may not be until late September. Anyone that bought in March could need to wait six whole months before receiving a penny. So for half a year, the current yield is zero. The investor is not getting anything. So yes, anyone who bought and held from March will get $10.60 in the first four dividend payments (assuming the $2.65 is the actual payment), however, it may take 18 months of them holding the stock to get all that. That means that the annual yield is much lower. $10.60 on a $600 stock is a 1.76% annual yield, but over 18 months, it is much less.
So what should dividend investors do? Well, here's a couple rules to remember (and hopefully follow).
- What Yield? Remember the difference between current yield and your yield. There's a huge difference between the investor who bought $500 shares at $28 today and will get $100 in quarterly dividends, and the investor who holds 500 shares at $28 and has lost $1,000 already. Don't be the second one.
- The Quarter Rule. When I trade, my timing is usually terrible. If I buy something, there's about a 99% chance it will trade lower at some point. Generally, it occurs within 5 minutes of me buying it, but usually at some point that day. In an attempt to avoid that rule, I do the following. I find a price at which I want to enter that stock, and then subtract an amount, usually a quarter. But it does depend on the name. For Apple, you may want to subtract a dollar or two. Sure, there's a chance that your trade might not go through that day, but unless you have to be into that name on that day, you probably can wait. The general purpose of this rule is to avoid impulse purchases.
- Time. Remember that dividends are not interest. If you hold a company for 350 days of the year, and it pays $3.65 in annual dividends, you don't get a penny a day, or $3.50. You could well get all $3.65, but if your timing is off, you could actually get $0. You have to hold the stock on that date when the company records who the shareholders are.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.