Are stocks a good source of income?
That’s the question for a lot of investors these days. With money market yields at zero and long-term bond yields not much higher, many are turning to stocks to replace their income needs. After all, dividends from some blue-chip companies seem quite attractive.
But not so fast. We’ve discussed before how stocks are a residual claim on corporate cash flow. That means that they are the last in line to get paid. Companies have many competing claims for their money—employees, pensions, bonds. If those claims get too strong, the dividend may be reduced.
Usually we can predict when a dividend is likely to be cut. Undercapitalized banks are a great example. After the Crash of 2008 lots of banks were still paying fairly generously. But after they took TARP money to shore up their capital someone from Washington called explaining that taking taxpayer money and paying shareholders generously was inconsistent. In short order, bank dividends were cut to nominal levels.
Right now there are some generous sectors, in terms of dividend yields. But you have to understand the risks. Pharmaceutical companies pay well, but they’re under pressure due to expiring drug patents and health care reform. Defense contractors are dividend-rich, but their funding source is a government facing huge deficits and many of them have pension-funding issues and an aging worker-base.
Every firm is different. But it’s important for people buying stocks for income to do their homework and remember that some returns entail greater risks.
Douglas R. Tengdin, CFA
Chief Investment Officer
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