Should You Dump These Dividend Stocks?

When both the stock market and interest rates were hitting bottom last year, dividend stocks with stable payouts offered investors the best of both worlds: great bargains and high income. Yet after the market's big rally, many stocks have seen their dividend yields drop sharply. Do those falling yields mean that you should get out of your dividend stocks now before it's too late?

A look at the numbers
A company's dividend yield depends on two numbers: the amount of its dividend and the current price of its stock. For the most part, dividend payouts stay relatively constant; a company might raise or lower its dividend occasionally, but such moves don't usually happen more than once a year.

On the other hand, stock prices can fluctuate wildly over short periods, as we've seen lately. When they do, they can have a dramatic impact on a stock's dividend yield, even if the dividend itself doesn't change much. For instance, compare the yields that these dividend stocks were paying back in March with what their current dividend yields are.

Source: Yahoo! Finance. Yields shown are for trailing-12-month dividend payments.

Clearly, the big rise that share prices have experienced over the past eight months has had a dramatic downward effect on dividend yields. And while not all of these stocks look overvalued from a quick glance at their P/E ratios, several no longer resemble the values they were when their shares were much cheaper.

If you focus solely on yields, then you may be tempted to sell some of these stocks in favor of searching out higher payouts. Yet doing that could be a huge mistake, especially because the alternatives are still less than ideal.

No substitute
There are always two considerations for every decision to sell a stock. First, you have to decide that your current investment has lost some of its initial appeal or faces new obstacles that endanger your capital. But just as importantly, you need to look at the investment you'll use to replace the one you sell and conclude that it's a better choice.

Right now, the alternatives to dividend stocks are less than ideal. If you sell out and keep your cash on the sidelines, you'll be hard-pressed to earn more than 2% in an FDIC-insured bank account, and both money-market funds and short-term Treasury bills pay far less than that. If you instead seek to increase your income by locking up your money for a long time, you'll still struggle to break through 4%.

Moreover, as rates have languished, yield-starved investors have poured into bond funds at an alarming rate. That has helped suppress yields, but it will also result in big losses for bond-fund shareholders when interest rates start to rise again.

Look for growth
In addition, taking a long-term perspective is important. Beyond current yield, you should also look for stocks that will increase their dividends over time. For instance, Coca-Cola has seen its payout rise at about a 9% annual pace over the past five years. Novartis boasts a 17% annual dividend growth rate. Merck, on the other hand, hasn't changed its payout since 2004.

So even if a stock like Merck has a higher yield at the moment, you might still prefer a lower-yielding stock with a higher growth rate if you intend to hold onto it for a long time. Eventually, if the dividend continues to grow more quickly, its yield will outpace that of the slower-growing stock.

It's true that many dividend stocks are offering lower yields than they did earlier this year. But just because dividend yields were abnormally high in February and March, that doesn't make today's lower yields a bad deal. Given the lack of better alternatives and the potential for those companies to increase their dividends over time, you'd be well served to hang onto high-quality dividend stocks for the long haul.

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