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I like dividend paying stocks and have been writing about their virtues since early 2009, well before they became the rage on Wall Street. I like them for a few reasons. Most large, mature U.S. companies can pay a decent dividend without hurting their EPS growth, so it enhances investors' total return. Unlike share buy-backs, dividends continue to be paid during recessions, generating cash that can be invested in stocks when they are cheap. Dividends impose more financial discipline on corporate managements than share buy-backs because they have to be paid every quarter and are far more transparent. Unlike dividends, buy-backs can be announced but not executed, or executed but offset by issuance for acquisitions or employee stock options, so the share count does not actually decline. Finally, dividends are convenient -- investors don't need to decide when to sell shares.

But these virtues must be kept in perspective. Using dividends as the primary stock-picking criterion is a good way to lose money. The value of a company is determined not by its payout policy, but by its fundamentals -- its ability to earn returns above its cost of capital and to generate free cash flow. Dividends are not necessarily a good indicator of these fundamentals. Many companies with poor fundamentals can afford to pay high dividends, at least for a while. Indeed, some firms, including quite a few utilities, are effectively financing their dividends not with internally generated funds, but rather by issuing new shares. High yields can be particularly deceptive, because they are lagging indicators. When the fundamentals of a company are deteriorating (think GE (GE) in 2008), corporate boards of directors are the last to know; as the stock price slides the dividend yield will rise, enticing investors until the board wakes up and belatedly slashes the dividend (think GE in 2009).

One good example of the risk that comes from putting the dividend cart before the fundamentals horse is Standard & Poor's "Dividend Aristocrats" -- 51 stocks in the S&P 500 that have raised their dividend every year for at least the last 25 years. Specifically:

  • Quite a few of the Aristocrats are feeble and fading old-line companies. Of the 51 stocks, 10 are expected to grow their dividends by 4% or less in 2012, and 17 by 6% or less. Average 2012 dividend growth for all 51 is 8%, well below the 14% forecast dividend growth of the entire S&P 500 (S&P dividends rose 14% in the first half of 2012).
  • As one would expect, the list is skewed toward such sectors as industrials, materials, and consumer staples. There are no biotech companies and only one technology stock -- slow-growing ADP. The list completely overlooks one of the most exciting trends for dividend-oriented investors -- large, powerful, cash-rich tech companies such as Intel, Apple (AAPL), Microsoft (MSFT), Qualcomm (QCOM), and Cisco (CSCO) are raising their dividends rapidly. The aristocrats also exclude younger consumer companies such as Nike (NKE), Starbucks (SBUX), Foot Locker (FL), Darden Restaurants (DRI), etc.
  • The mean payout ratio of the Aristocrats is fairly high at 46% (versus 28% for the S&P 500), and 13 companies have payout ratios of over 60%. This suggests that future dividend growth will be slow.
  • The list is also badly skewed by the financial crisis, when virtually all major banks were required by regulators to cut (or at least not raise) their dividends in order to strengthen balance sheets. Many of these banks are well-managed, attractive plays on a U.S. housing recovery, and they have the added virtue of little or no exposure to Europe.

Bottom line: It is a mistake to simply invest in the Dividend Aristocrats Index (or an approximation thereof), because you will own too many weak, slow-growing companies while systematically avoiding attractive sectors such as technology and banks. It makes more sense to use the Aristocrats as a "shopping list," favoring those stocks that have fairly strong dividend and earnings growth, positive stock price momentum, dividend payout ratios below 60%, and rising consensus EPS estimates. To these should be added quite a few non-Aristocrats with strong fundamentals, decent yields of 2-4%, and rising dividends.

The Aristocrats' defenders may protest that they have tended to beat the market over time. Perhaps so, but keep in mind that recently, the market has favored stocks that pay dividends and are in defensive sectors, such as consumer staples. Stocks fitting that description (including many Aristocrats) have become fairly expensive and may not continue to outperform, particularly if their fundamentals are lackluster. The boilerplate caveat, "Past performance is not an indicator of future results" is definitely relevant here.

Source: Dividends: Beware Feeble And Fading Aristocrats