As bond yields keep falling amid worries about an escalating trade war and a slowing economy, dividend-paying stocks become more attractive to income-seeking investors. But picking the wrong ones can wreak havoc on your returns.
This year, yields on 10-year Treasuries have fallen over one percentage point to 1.675% as of Wednesday—their lowest level since 2016. Yet U.S. corporations continue to return cash to shareholders by increasing their dividend payments. According to Howard Silverblatt, an analyst at S&P Dow Jones Indices, this year’s total dividends of S&P 500 companies are expected to grow 6.2% from 2018—the 10th consecutive year of rising dividends in the large-cap index.
About 58% of the S&P 500 stocks now have higher yields than 10-year Treasuries, according to Keith Lerner, chief market strategist at SunTrust Private Wealth Management. Over the past three decades, that percentage was an average 17%. Many dividend-focused funds are seeing elevated interest as investors seek alternatives to their bond exposure.
Despite having similar names, though, many dividend strategies are vastly different from each other.
One can simply select the stocks with the highest dividend yield—the annual dividend payment relative to share price—and harvest the most income from their investment. Such high-yielding strategies tend to favor more-established industries and mature companies, which typically aren’t growing very quickly and can distribute more earnings back to shareholders rather than spending on acquisitions and investments.
The Vanguard High Dividend Yield exchange-traded fund (VYM), for example, has Johnson & Johnson (JNJ), JPMorgan Chase (JPM), Exxon Mobil (XOM), and Procter & Gamble (PG) as its top holdings. All are blue-chip names with stable earnings and a dividend yield ranging from 2.6% to 4.9%, much higher than the average yield of 1.9% for the S&P 500 (.SPX).
But higher yields often come at the cost of growth, and blue-chip stocks tend to have cheaper valuations and weaker performance when the broader market is going up. The Vanguard High Dividend Yield ETF trades at only 16.6 times earnings, versus the S&P 500’s 22 times. As the broader index’s price has climbed 15% year to date, the fund grew only 9%. Even with all dividends reinvested, the total return still lags the S&P 500 by five percentage points.
Another approach: Pick the stocks that have seen consistent increases in their dividend payments, even though their yields might not be that high. Continuous dividend growth is often a sign that the company is doing well financially, with higher earnings and cash flow to deploy. While the dividend growers sport only modest yields, their stock prices tend to rise more in up markets, leading to strong total returns over the long run.
For example, two of the top holdings in the Invesco Dividend Achievers ETF (PFM)— Microsoft (MSFT) and Visa (V)—yield only about 1.4% and 0.6%, respectively. But both have more than doubled the year-to-date gains of the S&P 500 and have helped lift the ETF’s performance.
“Growers have better performance in periods of rising interest rates and stronger equity markets,” explains Nick Kalivas, senior equity product strategist for Invesco’s ETFs, “They’re a more offensive type of dividend play, while high-yielders tend to be more defensive and perform better when the economy is slowing and rates are falling.”
Still, investors need to be aware of so-called dividend traps. If a stock’s dividend yield is simply too good to be true compared with its peers, it could be caused by a falling share price. And even if a dividend is legitimately high, it might not be sustainable if a company has high debt loads, low cash flow, or unstable earnings.
If yield is the only consideration, such risky names might well be included, putting investors in danger of sudden price drop. That’s why many dividend-focused funds also have other criteria in place for stock screening. “None of them are foolproof, but they are trying to avoid the dividend trap through different means,” says Kalivas.
The iShares Select Dividend ETF (DVY) picks only stocks with consistent five-year records of paying dividends. The Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) selects high-yielders that also showed low price volatility over the past 12 months. The Global X S&P 500 Quality Dividend ETF (QDIV) ranks stocks on both dividend yield and other quality measures such as debt level and profitability. The Invesco S&P Ultra Dividend Revenue ETF (RDIV) simply eliminates the top 5% high-yielders from the portfolio.
But all these additional requirements are likely to make the dividend less of a pure play—meaning it could end up generating less income. “One of the challenges of building a dividend—or any factor—portfolio is that once you start putting constraints on it, you are weakening the exposure to the factor you are looking for,” says Jay Jacobs, head of research and strategy at Global X ETFs.
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