Dividends matter.

Lowered tax rates on dividends make them matter even more.

I get all that, but chasing yield in stocks is an interesting phenomenon these days. Many advisors are suggesting that now is the time to buy stocks that pay dividends. They say it’s a safety thing and that if the market pulls back, you’ll at least get the benefit of some income. Personally, I think this is nonsense. I can understand this comment back in 2000 to 2003 when the market was in a steady decline. I can especially understand it in 2003 when the dividend tax cut was put in place. I can even agree that it was a good thing to do as earnings picked up and dividend payouts increased along the way. I can also understand how you might want yield from stocks when money market rates were declining or sitting at about 1%. But now? That I cannot understand. Just pull up any of your favorite dividend stocks and most of them will have probably increased about 100% since 2003. Make it easy on yourself and pull up a 10-year chart of the IShares Dividend ETF (DVY). At the beginning of 2003, it was trading around $40 and now it’s at $70 (a 75% gain). How much reward is left and how much risk is there?

In early February, GM cuts its annual dividend by 50%. Prior to that, many people were being told to buy GM for the high yield (8%) and because Kerkorian was investing. Neither of those turned out to be longlasting. However, an investor that bought GM the day before the dividend cut and held until today would still have made a bunch of money, but their dividend yield would have gone way down. The only reason for the gain is $7.50 of appreciation in the share price, but if you were buying just for the yield, it’s not good. Just as a price increase like GM’s can rescue you from a dividend cut, a negative change in the share price can rapidly eat at your total return. So if you insist on buying a dividend paying stock, you better make sure that the share price at least holds constant.

One of the things I looked at was the current dividend yield for many of these stocks versus their 5-year historical average yield. Most of them are less today than the average and that is a warning sign. I also don’t find many of their valuations to be cheap relative to their historical averages and that’s saying a lot because dividend paying stocks are typically considered to be in the “Value” category. Lastly, money market rates are pretty high right now and if adequately insured, the deposits have no “principal risk”. If you already own a dividend stock, I am not advocating that you sell it. You need to evaluate so many things and the most relevant one is the historical yield on your purchases. If you bought a stock 5 years ago at $40 and it is now paying you a $4 annual dividend, I’d feel great about having a 10% return. It would be tough to sell that stock and reinvest the proceeds in something equivalent.

There are several factors to analyze a good dividend paying stock and the web or your financial advisor can help you with those. But here are some of the things I evaluate:

• Size of yield (high yields may be pricing bankruptcy risk or dividend cut risk)
• Current yield vs. 5-year historical yield
• Earnings per share vs. Dividends per share
• Free Cash Flow per share vs. Dividends per share
• Expected Earnings Growth Rate vs. Expected and Historical Dividend Growth Rate
• Forward PE vs. Historical average PE

If you are a member of HEDGEfolios you can easily sort the EVALUATE section by using the Income criteria box and select “All Yields” to find stocks that pay a dividend (about 1500 of the HEDGEfolios universe) or dig deeper by selecting Low, Mid or High Yield. You can also get a bigger picture of the Income stocks by selecting ANALYZE - STOCKS and scroll down to the Income section. Banks, Utilities, REITS, Telecoms, and Consumer Staples are pretty common sectors to find stocks that pay a dividend.

I think dividends are great and yet, hearing these blanket statements about buying them right now is questionable to me. As I said, that was excellent advice about 4 years ago, but I think it’s dangerous advice today. If rates decline further and the yield curve remains inverted, we are probably heading to a recession. Typically, these “widow and orphan” dividend paying stocks were looked at as safe bets for weak economies. If the hard landing appears, I don’t think many of them will be spared just as the old AT&T was not spared in 2000. If the economy starts to strengthen, rates will increase and money will come pouring out of these stocks to fund investment into the capital appreciation offered by growth stocks. I seem to be on my own with this opinion but dividend yields are not high enough for me to offset the risk that the share price will get whacked. If you are looking for yield, money market rates are much more liquid, have no principal risk (if insured) and the money market rates of about 4% are superior to the average S&P 500 dividend yield of 2%, even after paying the incremental taxes. In the words of a smart friend of mine, I don’t dislike dividend stocks, I just dislike bad dividend stocks. When you hear someone pushing you to buy a stock because of its dividend, you have a lot of work to do to make sure that the stock is good before the dividend matters.