Investors have had an insatiable hunger for dividend stocks throughout the bull market of the past four years. In fact, a number of signs suggest that they've gotten too hungry, leading them to make fundamental errors in judgment in going after high-yielding dividend payers no matter what the cost.
The siren song of dividends
With their substantial income and their perception of being less volatile than their non-dividend-paying counterparts, dividend stocks have been more popular than ever among investors who got burned by the financial crisis and ensuing market meltdown nearly five years ago. Especially as the broader stock market has soared to new highs, few investors are willing to take on the apparent risk of growth stocks, choosing instead to focus on income-producing stocks and count on their dividend income as a buffer against potential future losses.
But you can see in several places the consequences of the stampede toward high yield. Here are just a few:
- Closed-end funds Cornerstone Progressive (NYSEMKT: CFP) and Pimco High Income (PHK 2.83%) both make fixed payments back to fund shareholders on a monthly basis, and their distribution yields are truly extraordinary, at about 17% and 12%, respectively. Those dividends have enticed shareholders to pay $1.30 to $1.40 or more for each $1 of assets in the funds. Yet during most months, a substantial portion of those distribution payments has simply been a return of investor capital rather than true income from the funds' investments.
- A recent study discussed in The Wall Street Journal found that returns on a portfolio with a combined value and dividend-income strategy outperformed a strategy focused more exclusively on maximizing dividends by an average of 1.7 percentage points per year, a huge edge in long-run returns.
- In the dividend ETF arena, most funds tend to focus on maximizing yield. Although the popular Vanguard Dividend Appreciation (VIG 1.88%) ETF bucks the trend by screening first for consistent dividend growth and only then looking at yield as a factor, many rival ETFs start with high-yielding stocks as their baseline and only then consider other desirable traits. Others focus solely on high-dividend niches of the market, such as iShares FTSE NAREIT Mortgage-Plus (REM 1.48%) and its concentration on high-yield mortgage REITs.
When dividend stocks get too popular, their prices get out of line with both their dividend income and the fundamentals of the businesses that underlie those stocks. In simpler terms, when dividend stocks become bad values, it's time to consider looking elsewhere for a margin of safety.
Be smart about being safe
Dividend stocks have traditionally protected investors from downturns, and they will again in the future. But in the midst of a dividend-stock craze, you shouldn't rely on them to deliver the performance they have in the past.