Chasing Yield?

Is it a good idea to buy dividend stocks?

In an environment where short-term interest rates are zero and bonds yield less than inflation, many investors are turning to dividend-paying stocks to provide needed income for their portfolios. And with blue-chip companies like J & J or Chevron yielding more than 3%, how risky can such a strategy be?

There’s a lot to like about dividends. They are the most transparent part of a company’s financials. Corporations may have to re-state income or sales or assets, but they never have to re-estimate how much they paid in dividends last year. And dividends represent a tangible commitment by management to shareholder interests. A steadily rising dividend payment stream indicates the company’s board understands shareholders should get some tangible rewards for the risks that they are bearing.

But dividends are risky. We’ve discussed before how equity represents a residual claim on a company’s cash-flow. It’s last in line after all the other obligations are met: employees, pensions, vendors, taxes. Dividends are a residual on the residual. They get paid after capital expenditures, real-estate investments, or merger and acquisition costs. That’s why fast-growing companies in dynamic industries often don’t pay much or anything in dividends. They need to hold onto cash to maintain operational flexibility.

Dividend yield isn’t real. It’s the end-product of a long and involved economic process. If you own a stock that pays dividends, your financial well-being depends on the company’s economic success. Don’t look for dividends. Look for well-managed companies in stable industries and the dividends will find you.

There’s nothing wrong with dividends. But chasing dividends in order to add income to a portfolio usually ends in tears.

Douglas R. Tengdin, CFA
Chief Investment Officer
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