For decades, dividend income has been a crucial component of a stock investor’s total return. It often surpasses returns from capital appreciation in volatile markets as income-seeking investors have widened their search for yield in the face of historically low interest rates, and dividends have served as a useful tool.
However, investors often take a flawed approach to evaluating dividend investments by focusing on the longevity and growth of dividend payments over time. The problem is that these metrics may not be indicative of a sustainable yield.
In the United States, the increasing demand for dividend income has been driven in part by valuations for many traditional dividend payers that are far above their long-term averages. Outside the United States, there are a number of companies in both developed and emerging international markets with historically high dividend yields.
Blindly focusing on dividend yield in the international sector, however, can be dangerous. Often, a seemingly generous dividend yield may cloud an ensuing weak share price tied to negative news not yet revealed in the quarterly dividend.
Clouded Judgment Through the years, several strategies have been adopted to avoid overpaying for dividend-driven yield. First, longevity. If a company has paid a dividend for a long time, investors may trust it will continue to do so.
The alternative, focusing on dividend growth over time, views a reduction in the distribution as a red flag, signaling the dividend may either be pared back or not paid at all in the future. Both approaches are flawed because:
1. They react to a reduced dividend only after it happens, resulting in holding the dividend-paying security until the next rebalance, well after the market bakes the negative dividend news into the stock price.
2. They require a long history of dividend payouts (often a decade or two) to properly evaluate a company, which means newer dividend payers are excluded from consideration.
3. They tend to downplay recent changes in the macro environment that may drastically affect the company’s ability to maintain or grow its dividend.