They were the best of yields, they were the worst of yields …
French Aristocracy. Remember what happened to them? Public Domain. Source: Wikipedia
In an environment where short-term interest rates are barely moving up and bonds are exposed to rising inflation, many investors have turned to dividend-paying stocks to provide income for their portfolios. Many blue-chip companies yield 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 financial statements. 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. Steadily rising dividend payments indicate that the company’s board understands shareholders should get some tangible rewards for the risks they carry.
But dividends are uncertain. Equities are a residual claim on a company’s cash-flow. Shareholders are last in line after all the other obligations are met. Bondholders, employees, vendors, and taxes come first. 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 secure. It’s the end-product of a long and involved financial process. If you own a stock that pays dividends, your financial well-being depends on the company’s economic success. Don’t seek out dividends. Look for solid companies in stable industries. The dividends are a by-product of good management.
There’s nothing wrong with dividends. But chasing dividends in order to add income to a portfolio often ends in tears.
Douglas R. Tengdin, CFA