Dividends are important, and one of the best things about the Dow Jones Industrials (^DJI -0.98%) is that every one of the 30 component stocks that make up the Dow pay a dividend. But when it comes to dividends, it is possible to have too much of a good thing if you simply pick stocks with the highest yields without considering any other factors. Let's look at one strategy that does exactly that and examine some of its shortcomings, including its emphasis on telecoms AT&T (T -1.37%) and Verizon (VZ -0.68%) and pharma stocks Merck (MRK 2.93%) and Pfizer (PFE -3.85%).
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Who let the Dogs out?
The popular Dogs of the Dow strategy does exactly what many dividend investors do: aim for the highest-yielding portfolio possible. Under the strategy, you choose the top-yielding stocks in the Dow Jones Industrials at the beginning of the year and hold onto them throughout the year, replacing them with the next crop of high-yield stocks the following year.
The Dogs of the Dow did extremely well last year, outperforming the Dow Jones Industrials by about four percentage points. But unfortunately, that track record hasn't been consistent. In 11 of the past 18 years, it has underperformed the Dow itself.
Part of the reason for the Dogs of the Dow's performance is that the same stocks tend to top the list each year. For instance, AT&T and Verizon have once again been named the top two Dogs of the Dow for 2014, marking the fifth consecutive year they've led the list. Moreover, looking further back at history, telecom stocks have consistently been among the top yielders of the Dow over the years.
But both AT&T and Verizon have much different businesses than they did when they joined the Dow. The days of utility-like legacy landlines are largely over, and both Verizon and AT&T have now become primarily mobile network giants, requiring huge capital outlays to support their growth. Recently, that has worked out well for AT&T and Verizon, as the revolution in mobile devices has given them pricing power almost to name their own price for data plans. Yet unlike their landline networks, which served them well for generations, mobile networks that adequately handled customer loads for a short period can become obsolete in the blink of an eye as new devices continually test their limits. Moreover, an imminent price war from smaller operators could destroy the competitive advantage that AT&T and Verizon have had for years, especially since neither Verizon nor AT&T have a substantial international presence.
Meanwhile, big pharma stocks Pfizer and Merck have been among the top five Dow Dogs for the past four years, as well as at various times in past years. Yet current high yields reflect vast uncertainty about their future. Investors foresaw years in advance that both Pfizer and Merck would have blockbuster drugs coming off patent, and share prices fell in light of that uncertainty, boosting dividend yields. These companies have seen their share prices stay relatively strong despite the huge revenues they've lost to generic competition. Yet the challenges in getting new drugs approved have plagued both Merck and Pfizer recently, forcing the companies to accept setbacks from time to time. Eventually, both companies will likely find new blockbuster prospects. But until then, dividend investors will have to be careful to make sure earnings stay high enough to sustain their payouts.
It's tempting to look at the highest-yielding stocks in the Dow Jones Industrials as sure things. But relying solely on yields can create a big trap if you're not careful.
