Updated: Sep 8
"Almost everyone you talk to currently seems to love dividends as interest rates have fallen and investors search for yield." - Meb Faber, Cambria Funds
I was scrolling through Twitter when a tweet caught my eye.
What's the worst advice you've ever received?
My mind raced back to my childhood. I was a big Simpson's fan. I recalled a scene where Bart was down about a school assignment failure. Homer puts his arm around Bart and says, "If you can't win, don't try."
Still makes me chuckle, but obviously horrible advice.
I started to think about the worst investing advice. I kept coming back to one misguided theme:
Something to effect of: Cash, CDs, bonds, etc. are yielding next to nothing; buy dividend-paying stocks instead. Here's a real-life example...
“If you’re a young, wet-behind-the-ears broker at Goldman Sachs, I would tell you to forget all of those bond ideas, just tell your clients to buy the stocks of terrific companies with fantastic nation-state-sized balance sheets,” the host said. “You’ll do much better with a heck of a lot less long-term risk and more dividends.” - Jim Cramer, CNBC Mad Money host.
Not to pick on Cramer (ok, maybe a little bit) as he's hardly the only culprit. One doesn't have to look far to find similar messages from prominent global banks.
Using dividend paying stocks to replace "lost" income from safe investments is horrible advice. Look no further than what's happened in 2020:
Source: Bespoke Investment Group
The above graphic shows the top dividend-paying stocks from the Russell 1000 index (data as of 9/10/2020). The far right column shows the highest dividend payers in the index. The YTD total return column, littered with red, shows the total return for the stock (dividend + appreciation/depreciation) for 2020. Even when factoring in the lofty yields, the majority of these stocks saddled investors with massive losses.
The above graph breaks down the Russell 1000 index by deciles (highest dividend payers to lowest yielders from left to right). You can see the worst performing stocks were the highest dividend yielders (left). This is a good reminder that dividends offer little to no protection from general market selloffs.
In a zero rate environment, dividend investing seems like an attractive proposition. The lack of income producing options makes the space very attractive to investors. In theory, that’s correct. In reality, it’s been ugly.
2020 is providing a harsh lesson to those purchasing dividend paying stocks as a proxy for safer, income producing assets i.e. CDs, money market, investment grade bonds, etc.
To be clear, we aren't saying dividend strategies are bad. A core equity portfolio with a dividend tilt is fine. The problem lies when a conservative investor is trying to manufacture income and gets blinded by yield. A security offering outsized yield has risk embedded somewhere. Your job is to find it. Risk doesn't go away, it just shows up in a different form.
We've found that there's almost a mythical aura surrounding dividends. Here's what we would keep top of mind when building or owning a dividend-centric portfolio.
Myth #1: There's a belief that dividend stocks are safer than non-dividend paying stocks. That might be true in some years and false in others. It certainly wasn't true in 2020...
The above chart shows two popular high dividend ETFs (orange and purple) vs. the S&P 500 (blue). Notice the two dividend ETFs had a bigger drawdown at the end of March and have trailed on the way back up.
Myth #2: The yield is higher on dividend paying stocks, therefore, they must produce higher returns than bonds. Maybe. Maybe not.
The above graph shows the Barclays Aggregate Bond index (blue) vs. two dividend ETFs (orange and purple). Low yield doesn't mean low return and vice versa. We must take into account the underlying gain or loss of the asset. For risk averse investors, do not shun bonds and pile into dividend-paying stocks like they are equals. You will likely be disappointed.
Myth #3: My dividend won't be cut. Dividends are a privilege. They are not promised. According to CNBC, 639 companies cut their respective dividend in the second quarter of 2020. This includes over 60 companies within the S&P 500:
The above chart shows the number of dividend cuts for S&P companies (as of June 30, 2020). If the business doesn't earn a profit, can't service its debt, or is on the brink of insolvency, management has a duty to shareholders to cut the dividend.
Myth #4: I don't care what the stock does as long as I get my dividend. Would you rather own a stock with a 30% dividend yield, but goes down in value by 50% (negative 20% total return) or a stock that pays a 0% yield and appreciates 10%? A rational investor would take the latter every time.
An investor in any asset class should only care about total returns, not just dividends, income, dividend increases, dividend growth, etc.
For more reading on dividend investing, please see "Want Dividend Yield? Here's Where to Look." & "Can High Dividend Income Replace Paltry Bond Income?"