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Investors have spent the past several years gravitating toward dividend stocks. In an interest rate environment in which it's a whole lot harder to make ends meet living off fixed-income investments, many income-hungry investors have turned to dividend payers as a key part of their income-generating strategies. Moreover, given the reputation dividend stocks have for being somewhat safer during market downturns than non-dividend stocks, many see them as a hedge against an end to the nearly four-year-old bull market.
But just because dividend stocks are attractive doesn't mean you should overpay for them. According to a recent survey, though, that's exactly what investors are doing with high-yield dividend stocks.
Paying up to get it now
A report from B of A Merrill Lynch yesterday gave an outlook on dividend-paying stocks for 2013. The report included an interesting fact: When you divide out stocks that already pay high dividend yields versus those that have the highest growth rates in their dividend payouts regardless of yield, the dividend growth stocks are at their biggest discount compared to the high-dividend stocks in two decades.
That's not terribly inconsistent with the trends that we've seen at The Motley Fool with respect to dividend stocks. Over the past several years, readers have been hungry for news about high-yielding mortgage REITs Annaly Capital (NYSE: NLY ) and Chimera Investment (NYSE: CIM ) , even as concerns over Annaly's ability to sustain its business have led to recent losses that have left long-term Annaly shareholders with break-even total returns over the past couple of years -- and Chimera shareholders with losses.
All other things being equal, shareholders will inevitably take the bird in hand that a high current yield offers. The problem, of course, is that those other things aren't equal. Compare Frontier Communications (NASDAQ: FTR ) against AT&T (NYSE: T ) , for instance, and you'll find two completely different businesses. Frontier is doing its best to squeeze every ounce of life out of a decaying landline business while seeking to convert its customer base to profitable products, and it therefore pays an 8.5% yield. AT&T's yield is much lower at 5.3%, but it has customers waiting in line for some of its hottest products, and its wireless network is on the cutting edge of technology.
The thing about Annaly, Chimera, and Frontier is that all of them have seen dividend reductions over the past several years. Because their share prices have fallen, yields have stayed relatively high, but longtime investors are getting a lot less income than they used to from those stocks. That's an awkward position for many income investors to find themselves in.
But choosing dividend growth over high yield can have the extra benefit of keeping you out of the trap of falling share prices and dividend income. One reason that the well-known Dividend Aristocrats have gotten so much attention recently is that the companies that qualify for the list have put together impressive track records of raising dividend payouts through thick and thin for at least 20 consecutive years. That level of dedication makes it clear that those companies believe in sharing their profits with their shareholders.
Still, being a Dividend Aristocrat doesn't by itself give a company a great dividend stock. Many members on the list have held their places there by making token increases of fractions of a cent per share, insignificant growth that fails to reflect the true condition of their underlying business fundamentals.
Over time, though, you can see the impact that consistent dividend growth brings. Even outside the Aristocrats list, Intel (NASDAQ: INTC ) provides a great example of how dividends can grow over time. Intel was extraordinary in the late 1990s and early 2000s simply by paying any dividend at all, but starting in 2004, the company started ramping up its until-then insignificant payout by leaps and bounds. Now, Intel pays 1,025% more in quarterly dividends than it did a decade ago, and its yield is now a respectable 4% -- and the shares have also given investors a 50% gain since their 2002 lows, even taking into account their recent swoon.
Wait and get paid
It's always nice to have cash in hand, but if the rewards from waiting are great enough, patience pays. Take a closer look at stocks with good dividend growth potential, and in the long run, you'll end up a whole lot happier.
Among dividend favorites, Annaly Capital ranks near the top, but its recent buyout offer of Crexus has some thinking the best days for Annaly may be numbered. Find out whether Annaly is still a buy by reading our latest research report on the company, in which our analyst runs through the future opportunities and potential pitfalls facing Annaly. Click here now to claim your copy.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.