Why Dividends Make Sense Now

August 02, 2019

Why Dividends Make Sense Now

By Berkeley Harrison, CFA

Time for a different allocation?

Volatility has returned to the equity markets, as evidenced by an increase in the VIX (a popular measure of the U.S. stock market’s expected volatility), from 12 in mid-April 2019 to over 20 in late May 2019. The traditional antidote to stock market volatility is long term Treasuries.

Unfortunately, yields on Treasuries (2.0% for UST 10 year) are disappointingly low and expected to stay “lower for longer”; the Federal Reserve has already signaled that they are willing to cut the Fed Funds target rate as needed to support the economy. With more volatility in stocks and relatively low bond yields, clients are seeking higher portfolio yields without taking undue risk.

What is an investor to do? Dividend-paying stocks may offer protection against rising uncertainty and slowing profit growth. An income stream from dividends (normally paid quarterly) provides a source of return that often generates roughly one-third of a stock’s total return. For example, the current dividend rate for the S&P 500 index is roughly 2%.

Are dividends like bond coupons? While dividends historically provide consistent, scheduled payments, they are not contractually obligated payments, like bond coupons. Dividend payouts are determined by each company’s board of directors, and can be maintained, increased, or even eliminated at any point.

What are common investor mistakes when buying high dividend stocks?

  1. Blindly chasing dividend yields. Many high dividend-paying companies have run out of good investment opportunities within their own firm or industry. Don’t buy stocks with inconsistent earnings or poor outlooks.
  2. Concentrated portfolios. Some investors only buy the 5-6 highest yielding stocks. If one or two companies falter in a concentrated portfolio, the total return of the portfolio will suffer disproportionately.
  3. Not all dividends are created equally. While most dividends are considered qualified (taxed at only 20% for lower tax brackets), some are taxed as ordinary income, with significantly higher marginal tax rates.

Is there a smarter way to invest in high dividend paying stocks?

Within your larger portfolio, we recommend that you consider a strategy with a diversified portfolio of companies currently paying dividends, likely to increase their payout levels, and supported by strong, growing earnings. In this manner, you get the ideal combination of another income stream (dividends) to complement bond coupon payments, as well as strong, long-term appreciation potential in the core stock portfolio.