Investing ideas come and go, the best are time tested and never fall too far out of favor. Dividend investing is just such a strategy, and it’s one that has come back into vogue.
Given the current Federal Reserve’s monetary policy and the recent declines in the equity markets, bond markets have been on fire through the end of the third quarter and into the beginning of the forth. As bond prices have risen yields have fallen sharply (bond prices move inversely to bond yields). How does this affect the average investor? It means that the interest return on bonds has fallen, and therefore holding bonds in a retirement portfolio will generate less income. This has caused money managers and individual investors to seek yield elsewhere.
As of the close of the third quarter (Q3 2011) the dividend yield of the S&P 500 at about 2.15% exceeds the yield on a 10 Year Treasury which stands at 1.80%, by more than a quarter of a point. This is something that does not happen often, and is clearly due in part to the current monetary policy in place by the Fed, which has pushed down interest rates to historic lows. It is likely also due in part to stocks being cheap in relative historic terms. If you believe in the strength of the U.S. economy over the long term, these facts would suggest that it is a very good time to be investing in large-cap stocks with attractive dividend yields.
There are some things to keep in mind while investing for dividend yield, among them; dividends are not guaranteed. In particularly difficult times, especially in an acute credit crunch as was experienced in 2008, companies may suspend dividends. And the suspension of dividends can punish a stock’s price, which causes a two-fold loss: the loss of the dividend income, as well as a decline in the value of the stock. For this reason it is important to know when investing in a company that it is financially strong, and has the cash flow to be able to support future dividend payouts.
Diversification is also an important consideration in putting together your dividend portfolio. Exposure to too few industries or sectors can create several risks, and these risks are among the very exposures we’re trying to avoid, especially in times of heightened uncertainty. Consider the 2008 financial crisis, when financial firms halted dividend payments en mass. Having been over-invested in financial firms would have caused dramatic losses in both portfolio value as well as income stream. At the same time a well-diversified portfolio of dividend-oriented equities would have fared relatively well.
Dividends that are unsupportable should also be a big red flag. Dividend yield is the percentage of the share price that is paid out annually as a dividend (Annual Dividends per Share / Stock Price per Share). So a stock with a $1 annual dividend per share, which traded at the last dividend date at $20 per share had at that time a 5% yield. That same stock, trading today at a $10 share price, would have a 10% yield. The very high yield coupled with the steep share price decline is likely to be a warning that this hypothetical company could be in dire straights, and that dividend may not be sustainable. Suffice it to say, that as with all things in life, “If it seems too good to be true, it probably is.”
One should also consider that if the economy and stocks enjoy a significant recovery, these sectors might lag the broader recovery. History however tells us that a well-diversified portfolio with a strong dividend yield will show strong compounded gains over time.