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:
“There are good reasons why even the most income-focused investors may need some growth in their portfolios. Take the hypothetical case of an investor with a $1 million portfolio who wants to withdraw $50,000 a year for living expenses. After 20 years, an investor earning 3% annual total returns would have less than half of his or her starting balance remaining, while one earning 7% would have more than $1.8 million in assets. After 30 years, an investor earning 3% a year would be scraping the bottom of the barrel while one earning 7% annually would have a nest egg of more than $3 million.”
4. Succumbing to home market bias. Average dividend yields are higher overseas, while stock valuations tend to be more favorable.
“The argument for global investing is a compelling one in light of the importance of portfolio diversification and the pending shift in economic power from developed nations to faster-growing emerging economies,” Ruff writes. “In the last 20 years, emerging and frontier markets have more than doubled their share of the world economy and now account for 47% of global gross domestic product.”
5. Having blue-chip tunnel vision. While investors may feel safer with well known large-cap dividend stocks, they have become expensive and over the last decade have produced lower total returns than small- and mid-cap dividend payers, according to the Forward study.
“These stocks offer a liquidity advantage, to be sure, but they don’t necessarily represent the best growth or yield opportunities, especially in light of their valuations. In our view, rising investor demand has made many blue-chip dividend stocks too expensive to consider,” Ruff argues.
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 How Not to Invest in Dividend Stocks.
“Perhaps it should come as no surprise that so many funds invest in the same ‘usual suspects,’” Ruff writes. “After all, many strategies rely on indexes to drive the composition of portfolios.”
7. Giving macro factors too much weight. While investors may be justifiably wary of risks in emerging markets or the troubled nations of Europe, these regions may still hold attractive companies that have a global revenue base or local-serving operations less likely to be affected by macro trends.
“Europe is an obvious example,” Ruff asserts. “At this point, the words ‘Eurozone’ and ‘crisis’ seem fused in our minds, and many investors are shunning European stocks as a matter of policy. Yet with some research it is certainly possible to uncover strong, dividend-paying European companies that derive a significant share of their revenues outside the Eurozone.”
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