After all, some stocks pay more income than Treasury bonds.
But is one dividend-paying stock just as good as another?
Are the highest dividends always the best dividends?
The answer is a resounding “no” to both questions.
The dividend yield on the S&P 500 is a little above 2%. Of course, some stocks pay far more than the average in dividends.
According to research by the American Funds, “equities that pay a higher yield, on average, than the S&P 500 may be paying out more in dividends than they can support. These yields may not be sustainable – and if a company is forced to cut its dividend, the share price is likely to fall along with it.”
That suggests that the best strategy for investors is not to focus on stocks with the highest dividends, but those with the ability to grow their dividends over time.
This is, in fact, the secret to obtaining the best investment results, say researchers at the American Funds.
“Investing in companies that not only offer dividends, but increase them, has shown over time to provide both growing income and higher total return than those companies that do not.”
Here’s a quick summary of the research behind this.
In a study covering the last twenty-five years (from 1987 to 2012), the lowest long-term returns were provided by two types of stocks; those that made cuts to their dividends, and those that pay no dividends at all.
Better returns were provided by stocks paying a steady but non-increasing dividend.
And the best returns were delivered by stocks that periodically increased their dividends, even if their dividends initially started at lower levels.
The differences between the different approaches were dramatic. “Those companies that have regularly grown their dividend payments have had a greater average annual total return than those with a steady dividend – and far surpassed the return on equities that either do not have dividends or have cut them.”
Here’s the takeaway for investors:
Don’t fall for the “highest dividend” trap. Some unwary investors pick stocks that pay the biggest percentage dividends, not understanding that those big payouts often mask sick business models or financial distress. The highest dividend rarely results in the best total return (which is all that really matters), and may foreshadow a declining stock price ahead.
Do be content with a modest but growing dividend. Over time, you’ll end up with more income and growth of income.
Don’t neglect international stocks. Many of the best dividend payers are based outside the U.S. and trade at attractive valuations, to boot.
Do use mutual funds and ETF to build a diversified portfolio. Let them do the heavy lifting; there are many excellent funds which have already screened hundreds of candidates to pick out the best mix of dividend-payers for you. We’ve seen too many “do-it-yourself” investors who end up with over-concentrated portfolios bogged down in one sector or another (think financials or utilities). As we know from the financial meltdown, that strategy can end very badly.
The conclusion: A well-designed dividend strategy, as part of a diversified portfolio, can increase your long-term income flows and help your money last longer.