Published January 30th, 2017 by Nicholas McCullum
Dividend investing is one of the most repeatable, surefire methods to build wealth over the long run.
Investing in subsets of the overall stock market with strong dividend histories and promising growth prospects has been proven to boost the return of investment portfolio.
One example is the Dividend Aristocrats – stocks with 25+ years of consecutive dividend increases. The S&P 500 Dividend Aristocrats Index has handily outperformed the S&P 500.
Over the past ten years, the Dividend Aristocrats have returned 9.7% annually compared to the S&P 500’s 7.0% – an outperformance of 2.7%. You can see the entire list of Dividend Aristocrats here.
The outperformance of the Dividend Aristocrats does not mean that dividend investing is foolproof. There are many ways to lose money with dividend stocks.
This article will describe some of the most common mistakes made by dividend investors, as well as steps you can take to avoid them.
Focusing on High Yield Dividend Stocks
Focusing on dividend stocks with excessively high yield will inevitably lead to trouble. When you see a 15% dividend yield, it’s probably too good to be true.
Companies simply cannot sustain such high dividend payouts unless they are trading at an almost impossibly low valuation multiple.
For instance, consider a company with a 20x price-to-earnings ratio and a 15% dividend yield. Assuming an arbitrary stock price of $10, it’s easy to see that the company has $0.50 in annual earnings per share (divide stock price by price-to-earnings ratio) and $1.50 in annual dividend payments (multiply stock price by dividend yield).
This equates to a 300% payout ratio, which is unsustainable. This company will undergo a dividend cut in the near future, which would trigger a sell according to The 8 Rules of Dividend Investing.
So a company with a typical valuation (20x earnings) cannot reasonably have a 15% dividend yield. But what if the company has an extremely low valuation? After all, high dividend yields are indicative of attractive valuations, all else being equal.
Consider the case where the same company was trading at a 5x price-to-earnings ratio with the same 15% dividend yield. At the same arbitrary $10 stock price, the company has $2.00 in earnings per share and $1.50 in annual dividends, which implies a 75% payout ratio. Depending on the industry of the stock in question, a 75% payout ratio might be reasonable – but a 5x price-to-earnings ratio is not.
A 5x price-to-earnings ratio is nearly impossible to find in today’s market. The S&P 500 Index has a price-to-earnings ratio of 25.8, which means a 5x price-to-earnings ratio represents a one-fifth valuation discount to the overall U.S. stock market.
While low valuation multiples indicate bargains, extremely low valuation multiples should raise red flags for investors. In most cases, there is some reason why the market has discounted the company in question, and careful research should be conducting before considering investment.
Investors may be wondering how reasonably valued stocks are able to have such unreasonably high dividend yields if it means a payout ratio above 100%. Stocks with dramatically high dividend yields are generally doing one of two things: financing dividends by accruing debt, or servicing these dividend payments via the sale of business assets.
Both of these behaviors are detrimental to long-term business health, and this will be reflected in shareholder returns.
What is the solution to focusing on high yield? While it may seem counterintuitive, low yield dividend stocks can be a great source of returns for your portfolio.
Many high-quality businesses have low dividend yields because management has decided to retain most of their earnings to drive future business growth. A few examples are:
- Hormel Foods (HRL): 1.9% dividend yield
- The Walt Disney Company (DIS): 1.4% dividend yield
- Walgreens Boots Alliance (WBA): 1.8% dividend yield
- General Dynamics (GD): 1.7% dividend yield
- Sherwin-Williams Co. (SHW): 1.2% dividend yield
The bottom line is that focusing on excessively high yield dividend stocks is detrimental to overall portfolio returns.
Dividend investing is most successful when investors purchase stocks with a long-term time horizon.
“The single greatest edge an investor can have is a long-term orientation.”
– Seth Klarman
Portfolio churn – the excessive buying and selling of investments with a short-term time horizon – removes the advantage from the toolkit of investors.
Unfortunately, the nature of quarterly dividend payment schedules has led some investors to begin ‘chasing dividends’ – buying a stock for one quick dividend and then immediately selling. This is a form of portfolio churn and should be avoided.
In practice, chasing dividends would involve purchasing the stock on the day before its ex-dividend date, and then selling the stock on its ex-dividend date. The total holding period is only a single day (sometimes even less than 24 hours).
There are four main reasons why this is harmful to a dividend investor’s mission.
First of all, this type of investment strategy is highly laborious.
An investor would need to sit in front of their computer screen all day, selling stocks that went ex-dividend and researching stocks to purchase that go ex-dividend the next day. Since most dividend investors are also working a full-time job, this strategy nullifies the benefits of semi-passive investing in high-quality dividend-paying stocks.
Secondly, frequent trading results in frequent brokerage commissions.
Since most brokerage commissions are fixed regardless of the size of the trade, an investor would need to be trading substantial amounts of capital for the ‘chasing dividends’ approach to overcome the brokerage commissions paid. The importance of reducing investment fees cannot be understated.
Third, long time horizons allow investors to defer capital gains taxes. These gains, which will be taxed upon sales, can be compounded pre-tax, providing a tremendous tailwind for long-term investors. This strategy has been practiced with great success by Warren Buffett, which has led to its name of the ‘Buffett Loan’.
For an example of the long-term performance boost provided by a Buffett Loan, consider the long-term performance of Berkshire Hathaway (BRK.A) with a very long holding period compared to its performance if the security were sold and re-bought each year (triggering a 20% capital gains tax).
Source: Yahoo! Finance
The black columns represent Berkshire’s returns with deferred capital gains tax, and the grey columns represent the company’s returns if the stock were sold and re-bought each year.
While the differences do not seem substantial during any given year, it becomes more noticeable when compounded over long periods of time.
Investors that chase dividends lose out on these deferred capital gains taxes and the additional compounding that comes along with them.
The last negative to chasing dividends is perhaps the most obvious – investors lose out on the stock price appreciation that inevitably happens to high quality businesses.
Looking at the S&P 500 in particular, it is estimated that more than half of the index’s total returns comes from price growth (with the remainder due to dividends). Thus, investors who buy and sell stocks only to receive single dividend payments miss out on a substantial portion of their potential total returns.
While dividend investing is certainly proven to be an easily executed investment strategy with strong return potentials, it is still quite possible to make mistakes along the way.
Avoiding excessively high dividend yields and the practice of ‘chasing dividends’ will be very helpful to the long-term performance of one’s investment portfolio.