Income investors like the lucrative payouts that come from dividend-paying stocks, and in recent years, they've had little chance but to look to dividend payers as their primary means of generating portfolio income. Now that interest rates look like they're on their way up, some market watchers fear that stocks like the Dividend Aristocrats are about to fall out of favor.
It's true that dividend stocks might be more vulnerable to a possible future downturn in the stock market than usual, in large part because they've been so popular as yield plays. But where I think critics misplace their concern is in focusing on Dividend Aristocrats -- because for these stocks, yield isn't the primary consideration behind their success.
What it takes to be a Dividend Aristocrat
S&P Dow Jones Indices defines Dividend Aristocrats as those S&P 500 component companies that have raised their dividends each year for at least 25 straight years. The overseers of the index look at how much a company pays in total dividends throughout the course of a year and then compares it to the preceding year. If the current-year amount is higher, then the streak gets extended and the stock remains among the Dividend Aristocrats.
Notice that the qualifications for Dividend Aristocrats don't include any minimum yield amount. In fact, several Dividend Aristocrats have almost embarrassing low yields, making it seem almost insulting to their peers that they're in the same group of dividend stocks.
The bearish argument for dividend stocks
The concern that some investors have is that rising interest rates will spur investors to take money out of Dividend Aristocrat stocks and into the bond market. As my peer Jordan Wathen recently discussed in his article "The Death of Dividend Aristocrats," income investors who prefer fixed-income investments like bonds will find it more attractive to return to bank certificates of deposit and Treasury bonds if they can get yields of 3% or more than they were when those yields were below 2%.
By this logic, bond and CD yields are now often higher than dividend yields for blue-chip dividend stocks. So for those unwilling to take any further risk of share-price declines, a move away from dividend stocks might seem imminent.
The missing piece of the puzzle
The assumption this argument makes is that the only reason income investors ever moved to stocks was to get yield. That's undoubtedly true for some people, but probably not for all of those who bought dividend stocks in recent years.
More importantly, those who focused on Dividend Aristocrats had already chosen not to give yield the top priority. The true value of Dividend Aristocrats is that their underlying businesses are able to support consistently rising payouts over the course of both upward and downward cycles of the economy. Their track records of growth are what make them stand out, not their yields.
For example, look at just a couple Dividend Aristocrats:
- General Dynamics (NYSE:GD) is one of the newest members of the Dividend Aristocrats, with a 26-year track record of rising payouts. Its yield is just 1.5%, but it's profiting from its defense exposure at a time when U.S. military budgets are expected to soar, and geopolitical tension around the world is supporting strong demand.
- Sherwin-Williams (NYSE:SHW) has a yield of just 0.8%, among the lowest of the Dividend Aristocrats. But the renewed boom in housing and rising demand from homeowners and professional contractors for paints and other coatings has caused the stock to soar more than 60% just since late 2016.
I could go on, but my point is clear: There's more to these stocks than just their dividend.
Don't count the Aristocrats out
Whenever you're looking at dividend stocks, it's important to look beyond yields to understand the true nature of the investment that you're making. Anytime you buy a stock, you're buying a piece of a business, and the success or failure of that business will play a vital role in determining your total return. Over the long run, while dividends do matter, investing in dividend stocks is about choosing a business that has the capacity to grow and dominate its industry.
You'll never get that kind of payoff with bonds or bank CDs. That doesn't mean fixed-income investments inappropriate for investors. But it does mean that even for the most conservative investors out there, selling shares of high-quality dividend-paying companies only because bond yields are ticking higher could be the biggest mistake you'll ever make as an investor.