The following is a guest post from Barbara Friedberg, MBA, MS, editor-in-chief of Barbara Friedberg Personal Finance, where she writes to show you how to build wealth.
This current low interest rate environment has created a lack of opportunities for investors looking for yield. With Bankrate quoting a 1.15% return on a 1 year certificate of deposit and a lofty 2.25% yield for the 5 year CD, investors are clamoring for yield. This historically low interest rate environment has led the yield starved masses to look towards dividend paying stocks as a method of bulking up their returns.
This article is not going to be another of those “dividends are wonderful” pieces. In fact, I’d like to share a dividend investing horror stories with you so that you understand the down side to this popular trend. Keep in mind, I have invested through the late 1990’s and into the dot com bubble of the early 2000’s when dividends were slammed and capital gains were king. Any one talking about “yield” was considered a fool when stocks were growing 15-30% annually!
So, what happened?
Being a university finance professor, I can’t help myself when it comes to market history. So excuse me if I step on my podium for a moment. Markets are cyclical!! Business cycles and trends come and go. In fact, let’s look at the annual dividend yield** (dividend/price) of the S & P 500 during the first year of each decade since 1881:
Data courtesy Standard & Poor’s and Robert Shiller.
As of November, 2011, the dividend yield of the S & P 500 index is 1.99%. There are some stocks paying much higher dividends than that. One would think that all you have to do is buy a high yielding stock and watch the dividends roll in. After all, the average yield will only go up, and the current yield of 1.99% is much closer to the historical low of 1.11% in August, 2000 than it is to the high yield of 13.84% in June, 1932.
Dividends are Only One Piece of the Return Puzzle
When you buy a stock, your expectation is the dividend will stay steady or rise and the stock price will also increase. That way, the total return will be positive. What happens when this does not occur?
Stocks are historically volatile. That volatility, measured by their standard deviation, means their prices go up and down. Investors don’t worry when the stock prices go up, that type of volatility is okay. But, when the prices go down, well, it doesn’t matter how great the dividend is if the stock price is half of the amount you paid!
Nokia was one of those incredibly popular stocks. They were at the forefront of cell phones and on a growth tear for many years. Their popularity was confirmed by the market granting them a lofty price earnings multiple of 59 in 2001. Who wouldn’t want to own a great stock with the largest cell phone market share in the world?
Consequently, being a value investor, I watched this stock for many years waiting for the PE ratio to fall into a more normal range. Fast forward to 2005 and 2006; At that time, Nokia still had a great product and a large market share, but their PE ratio fell from the stratosphere to the mid teens. I purchased many shares over those two years at reasonable prices ranging from the low $20s on up to a few shares at $30. Add the reasonable PE ratio to an awesome growth rate of over 25% in earnings from 2005 to 2006. I couldn’t lose!
In November, 2011, Nokia shares are trading at $6.75. For those without your calculators, that is a lot less than $20-$30 dollars per share. What good is a high dividend if the market landscape changes, and the company stock price falls?
Nokia was over taken by the higher margin smart phones. Those phones grew rapidly in popularity and Nokia was slow to adopt. Now, the company is playing catch up and partnering with Microsoft to gain a presence in the smart phone landscape. Meanwhile, they continue to lose market share. It is uncertain whether Nokia will ever regain its market dominance.
As this story illustrates, there’s more to investing than finding a great yield. You must research the growth drivers of the company, the competitive landscape, and be vigilant in monitoring your shares. A great dividend is no reward if the share prices tank. This was definitely a net loss situation.
Today, with a 6.75% yield, Nokia may be a better value. But a stock is never a good value if the company does not prosper!