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Dividend-Paying Stocks May Be Riskier Than Many Think

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Financial advisors and investors traditionally favor dividend-paying stocks as a key allocation in any comprehensive retirement portfolio, and Warren Buffett has famously earned billions owning such stocks. But Jim Cahn, chief investment officer of Wealth Enhancement Advisory Services in Minneapolis, says dividend-paying stocks are not nearly as safe or as remunerative as many think.

For one, says Cahn, dividend-paying stocks are more interest-rate sensitive than popularly thought and they will perform poorly as rates rise. He explains that investors owning these stocks as a substitute for bonds currently paying extremely low yields will likely lose value when rates rise, just like the bonds.

Also, says Cahn, “Some of the highest dividend-paying stocks tend to be some of the riskiest.” These include mortgage-backed real estate investment trusts, which are subject to even bigger losses as rates rise because they are often leveraged, says Cahn. They also include MLPs — master limited partnerships — which are subject to the volatility in the energy sector.

Dividend-paying stocks also tend to underperform, says Cahn. Since 2001, the Russell U.S. Large Cap High Dividend Index is up 99% on a total return basis while the Russell 1000 is up 130.8%, he says. Also, the Modigliani-Miller Theorem developed by Nobel prize-winning economists Franco Modigliani and Merton Miller “determined that payments of dividends has no impact on the value of a firm,” says Cahn.

Given this analysis, how should advisors and investors generate income?

Cahn suggests a rather radical approach: selling stocks that have appreciated in value, rather than buying bonds or dividend-paying stocks, to generate income. This strategy is “more tax sensitive,” and “you can time when you get the income,” says Cahn. “We prefer a program of investments that targets total return and then time the sales to maximize tax efficiency of a portfolio,” says Cahn. “That’s a much better strategy than chasing yield.”

Cahn does use bonds in the portfolios he manages but as a hedge against stock allocation for market downturns rather than as income-generating investments. He favors longer duration bonds — generally with longer maturities — “to offset stock market losses” rather than short-term bonds that many advisors favor now, at a time when rates are expected to rise.  Short-term fixed income securities are favored because they won’t lose as much value as rates rise and they can then be rolled over into securities paying higher interest.

But that approach failed last year relative to long-term bond portfolios. The Vanguard Extended Duration Treasury Index Fund and the PIMCO Extended Duration Fund, which favor long-term bonds, for example, returned more than 45% last year, according to Morningstar Inc. — well above the 11% in the S&P 500.

As for the stock portion of portfolios, Cahn uses what he calls “quantitatively enhanced indexing” plus individual stocks – focusing on high profitability and momentum with low volatility — all at a reasonable valuation. “Whether a company does or doesn’t pay a dividend is irrelevant,” he says.

— Check out Is Portfolio Diversification Overrated? on ThinkAdvisor.



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