(Originally Posted on October 14, 2010)
There are very few sure things on Wall Street, but one is Wall Street’s history of creating too much of a good thing. Think back to the biotech IPO boom, the dot-com frenzy, and more recently mortgage related securities.
Today everyone seems to jumping on to the dividend bandwagon. With baby boomers terrified that they won’t have enough income to fund their retirements, the trend is understandable. In the context of today’s low interest rate environment, the dividend story is compelling and history tells us that dividends are a significant component of equity investing returns.
What could go wrong?
A dividend driven investment that my mother recently made tells the story well. By way of background, my mother is a seasoned investor, my late father was a stockbroker and ran a brokerage firm that was founded by my grandfather in the mid 1930s, and both my brother and I have been involved in the investment industry for our entire careers.
The trade went like this:
Unhappy with the rate she was getting on her money market fund in early 2008, my mother bought some stock in General Electric. The stock had pulled back from about $42 to $32 and the company was paying a quarterly dividend of 31 cents per share for a yield of about 3.8%.
At the time she bought the stock, many pundits were advocating buying GE stock on weakness, highlighting that the dividend yield was attractive verses money market rates, and after all, it’s GE, what could go wrong?! I remember reminding my mom (she always tells me about her trades after the fact) of the old expression, “more money has been lost reaching for yield than at the end of a gun.”
We all know what happened next. GE’s share price made a beeline to about $6.50 a share, and oh yeah, the company cut the quarterly dividend from 31 cents per share to 10 cents.
So the dividend yield that she had invested for went from 3.8% to 1.2% with the stroke of a pen, and she had lost 80% of her principal.
With GE’s stock currently trading at about $16.50 per share, my mother’s principal loss on her investment at this point is about 50%. GE also recently raised its dividend to 12 cents a quarter so her current dividend yield is 1.5%. But, she’s going to have to collect a lot of dividends to get her original investment back, money that she had allocated to “safe” investments.
Outlook for dividend stocks
The best scenario for dividend investors is for the economy to continue to bump along with the Federal Reserve keeping the liquidity spigot wide open.
Should the economy materially weaken, dividend investors will need to start bracing for potential dividend cuts and or loss of principal.
If the economy materially improves, investment momentum will likely shift away from stable dividend paying stocks to highflying growth stocks. Also, a material improvement in the economy would be accompanied by higher interest rates and investors may opt for more stable fixed income securities over common stock dividends.
Capital structure 101
We hear over and over investment professionals making the pitch that investors should pick up incremental yield by investing in a company’s dividend paying common stock over its bonds. On the surface this may seem appealing, but keep in mind that you are talking about two entirely different asset classes even if the same underlying company issues the stock and bonds. Taking money from your portfolio that is allocated to bonds and investing it in equities significantly and materially changes the risk profile of your portfolio.
Companies are generally under no obligation to pay dividends to their common shareholders and as in the GE trade, dividend rates can be cut or entirely eliminated at the discretion of the Board of Directors. Also, in the event of a bankruptcy common stock holders, being at the bottom of the corporate capital structure, usually get wiped out.
On the other hand, when companies issue debt the bonds are usually backed by the assets of the company, and the company is obligated to pay interest and return the bondholders’ principal at maturity. In the event of a bankruptcy, bondholders are senior to equity owners in the capital structure and unlike shareholders, have a claim on the company’s assets.
It’s not surprising that some investment managers have a tendency to hype common stock dividend strategies as it is generally more profitable to manage a stock portfolio than a bond portfolio.
What to do
Allocating some equity exposure to dividend paying stocks may make sense, but moving money from a different asset class (cash or bonds) to pick up incremental yield in equities changes a portfolio’s risk profile dramatically.
The Federal Reserves’ ultra low interest rate policy combined with their ongoing quantitative easing has the effect of keeping interest rates artificially low while also propping up asset values. With this backdrop, investors seeking current income (most of whom are also seeking to preserve their capital) must be ultra vigilant when it comes to weighing the risks associated with dividend investing strategies.
After all, we don’t want too much of a good thing and in hindsight that measly money market yield my mother gave up, with guaranteed principal, is looking pretty good.