Why dividend stocks are popular again

This volatile stock market is showing the wisdom of owning dividend stocks and dividend-focused funds.

  • By Dan Weil,
  • The Wall Street Journal
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Dividend stocks are looking more attractive than they have in a while.

It’s a question of playing defense, given the current environment of economic, market and political uncertainty.

“We’re actually buying a lot more dividend stocks now,” says David Carter, chief investment officer at wealth-management firm Lenox Wealth Advisors in New York. “In a world of slow economic growth and political uncertainty, we’re trying to find ways to generate returns.” Collecting dividend payments from quality stocks is a good way to do that, he and others say.

Dividend stocks may not be as sexy as their faster-growing counterparts, which typically offer more price appreciation in rising markets, but they do provide investors with a steady stream of income along with the potential for capital gains. What’s more, dividend stocks tend to be less volatile than their nonpaying peers, and the companies that can afford to pay dividends often have strong balance sheets.

The Federal Reserve’s shift to a neutral stance on interest rates following three years of rate increases is adding to dividend stocks’ appeal right now, many financial advisers say. Rising interest rates usually hurt dividend stocks by pushing bond yields higher. That makes bonds more attractive to investors seeking income. Now there is talk that the Fed’s next move may be to cut rates.

While most investors buy dividend stocks for the steady income stream, that isn’t the only benefit these investments offer, financial experts say. Indeed, research shows that dividend stocks often outperform their non-dividend-paying counterparts over longer periods.

From 1958 through 2018, a portfolio with the top 20% of S&P 500 companies ranked by dividend yield and weighted by market capitalization outperformed the overall S&P 500 by 2.13 percentage points annually, according to Chicago-based Greenrock Research.

That’s partly because dividend payments account for a substantial portion of the stock market’s total return. Researcher Morningstar Inc. calculates that dividends were responsible for 19% of the S&P 500 index’s return over the past five years. Other research indicates much higher portions for longer periods, thanks to the compounding of reinvested dividends.

“Dividends are inherently a relatively stable and important part of total return,” says Chris Litchfield, a retired hedge-fund manager who is now a private investor in Greenwich, Conn.

Don’t be fooled

So how should investors go about choosing dividend stocks?

The S&P 500 (.SPX) currently yields 1.92%, and Mr. Carter says Lenox has been purchasing stocks with yields of about 4%. He and others stress that investors shouldn’t seek yields much higher than that. Extremely high yields often signal a company in trouble. Yield is calculated by dividing the annual dividend by the current stock price, so a very high yield could simply be a sign that the company’s share price has dropped sharply due to, say, weak earnings.

“High dividend yields often reflect that the dividend is uncertain and may be cut,” Mr. Litchfield says. “More money has been lost chasing yield than any other investment strategy.” A 6% yield or higher should give investors pause about pursuing a stock, he says.

Investors also want to make sure a company isn’t devoting too much capital to its dividends, because it might not be able to afford it without borrowing. In some cases, very high dividend payouts could indicate that not enough money is being reinvested in the business. In most cases, investors want the total amount of dividends paid out to be less than 80% of net income, Mr. Litchfield says.

What investors should look for is stocks with a history of dividend increases, as this is generally a sign of financial strength. Research shows that companies that initiate or increase their dividend historically outperform other stocks, including other dividend stocks, and have done it with lower volatility than the other stocks, according to Michael Sheldon, chief investment officer at RDM Financial Group-HighTower, in Westport, Conn.

Even with safe stocks, investors should be careful about what price they pay, says Mick Heyman, a financial adviser in San Diego. For example, “it’s hard to jump into Procter & Gamble Co. (PG) and Clorox Co. (CLX) at this point,” after recent increases in their share prices, he says. Dividend stocks such as PepsiCo Inc. (PEP) and Johnson & Johnson (JNJ) are better bargains currently, he says.

Dividend funds

When buying mutual funds and exchange-traded funds with a dividend tilt, investors should look at what sectors the fund emphasizes. “Sometimes funds load up on energy stocks, and you’re taking on risk if oil prices drop,” Mr. Carter says.

Jack Ablin, chief investment officer at Cresset Wealth Advisors in Chicago, points out that cyclical stocks, such as manufacturing companies, are unlikely to thrive in a time of low interest rates. “Interest rates drop for a reason,” he says, and that reason is generally economic weakness. Defensive companies, such a consumer staples, may make more sense now, he says.

Mr. Ablin says investors interested in dividend-focused mutual funds and ETFs should check out the following broadly diversified funds: SPDR S&P Dividend ETF (SDY), iShares Select Dividend ETF (DVY) and iShares Core High Dividend ETF (HDV).

SDY tracks the S&P High Yield Dividend Aristocrats Index, which includes stocks from the S&P 1500 index that have raised dividend payments for at least 20 consecutive years. DVY tracks the Dow Jones U.S. Select Dividend Index, which comprises companies with consistently high yields. HDV tracks the Morningstar Dividend Yield Focus Index, which also includes U.S. companies with sustained above-average dividends.

Low interest rates and slow economic growth likely mean muted returns for investors in the future, Mr. Litchfield says. “To the extent you can get 3 percentage points of 6% return from dividends, that’s probably pretty good.”

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