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June 19, 2013 at 10:35 AM
Oh sure, everybody loves dividends these days. As bond yields remain stubbornly low, investors and retirees are looking to dividend-paying stocks for income.
But there’s a catch. Seven catches, in fact, according to San Francisco-based Forward Management, which is the advisor to Forward Funds, which manages $6 billion of investment products for both individual and institutional investors.
Forward’s dividend investment team put together a report, How Not to Invest in Dividend Stocks, listing seven common pitfalls investors should avoid in their dividend strategies.
Dividend investing is very much back in favor right now, at the same time that fixed-income yields are near historical lows and a whole generation of baby boomers is at or near retirement age, writes report author David Ruff, a portfolio manager with Forward’s Dividend Signal Strategy team.
“Even USA Today anointed the ‘stodgy dividend-paying stocks that Grandpa and Grandma used to buy’ as the ‘new rock stars on Wall Street,’” Ruff says. “But whenever a strategy becomes the darling of financial advice columnists and bloggers, it may be time to proceed with extra caution. As straightforward as dividend investing may appear, investors commonly make mistakes that undercut both the income potential and the total return of their portfolios.”
Read on to learn about Forward’s list of seven mistakes investors should avoid.
(Read more about Forward at Genworth Wealth Adds 4 Strategists, 8 Strategies on AdvisorOne.)
1. Chasing lofty yields. “Counterintuitive, as it may seem, stocks with the highest dividend yields may not generate the best overall performance, as very high dividends are often unsustainable and may leave companies short of funds to invest in their future growth,” says How Not to Invest in Dividend Stocks author David Ruff.
The head of Forward’s Dividend Signal Strategy portfolio team advises investors to consider dividend payout ratios as well as yields.
“Our historical analysis across a variety of global markets shows that companies with the best long-term performance were those combining attractive—but not ultrahigh—dividend yields with relatively low payout ratios,” Ruff writes. “Based on our research, the sweet spot is a payout ratio in the 30% to 60% range—a percentage high enough that companies can commit to delivering regular, meaningful cash payments to shareholders, but low enough that they can reinvest capital for internal growth.”
2. Relying on overly mechanical strategies. Quantitatively driven strategies risk overlooking fundamental shifts or dividend policy changes that could jeopardize dividend income streams, according to Forward’s Ruff.
“For example,” he notes, “investors flocked to European dividend-paying telecoms based on their strong yields in 2011. A closer look, however, would have revealed that some companies produced those high yields with dividend payout ratios exceeding 100%—a clear signal that their dividends would not likely be sustainable for long.”
3. Overlooking growth factors. Rather than focusing solely on the dividend yields of stocks, investors should also consider their potential for dividend growth and capital appreciation, the Forward study advises:
6. Following the herd. Many dividend funds are index-driven, which can lead to “benchmark-hugging” portfolios that are overexposed to large-cap names while neglecting small- and mid-cap stocks with greater performance potential, Ruff notes in 