Dividend Investing is Not the Perfect Solution for Yield

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?

Finance 101

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

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?

The Takeaway

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!

Comments

[Nick]

Nice post. The temptation of a naked high yield has taken down many investors. Any opinion about the dogs of the dow strategy? From my analysis it outperformed for a while and then spent a number of years in ... ahem ... the dog house until very recently.

It seems silly to me to invest based solely on dividend yield, but it seems like so many people often don't look at other fundamentals before buying high yielders.

[mrp]

Really you post this as an example. What a joke. Get real and try posting something of value.

[Luis]

I don't know, Nokia is a large company but has a small market of products. What about choosing a diversified company like Oracle? I would guess that is a better dividend paying stock to purchase regardless of P/E ratio, etc.? Author, please comment, thanks.

[Matt]

Nokia was the thing back in the day.(1999) I had shares and it did rather well during the dotcom bubble. It was really big in europe and japan and not so much in the us. But like with all technology it changed quickly and became bleh.

As for dividend bearing stock stick with stocks you know and understand.(coke,pepsi,colgate) They will do well.

I was burned on a utility. It did rather well in dividends and share price but collapsed within one quarter due to regulatory change. I still made money but saw alot of the gains lost in three months.

[Nate]

This was a great article! Great point that just because a company has a high yield doesn’t make it a good buy. Where is the company going? What is its vision? Does it have a place at the table a decade from now? You really have to be able to answer a lot of those questions before you should mash the trade button. Else just hedge your bets and buy an index fund (not as sexy).

[Old Limey]

Our Trust account is 100% in municipal bonds that we're holding to maturity between 2012 and 2040.

Currently the average yield to maturity of our bonds is 4.99%, they pay us $153,667/year in tax exempt income and by the time the last one has matured we will have also received capital gains of $50,063. I actually invest all of the income into additional bonds as it's received so both the bond portfolio and the income it produces continues to grow every month.

The reason we don't need to touch any of the income is that every year we also transfer the MRDs from our IRAs into the Trust account, have some money witheld for state & federal taxes and then buy more bonds with the remainder.

Currently municipal bonds are doing very well indeed and a lot of other investors obviously seem to prefer them to common stocks.

The only caveat is that while 4.99% tax exempt growth is great for an older retired couple like us it's hardly enough to build the wealth necessary for a great retirement for a much younger person.

[tom]

Hindsight is 20/20.

Obviously you cannot predict the market, let alone individual stocks. This is why you need a completely diversified portfolio, even if the portfolio is made of 100% dividend paying stocks.

Your Nokia example is exactly the reason you need diversity. If Nokia was only 1% of your holdings, you would have only lost 1%.

This examples are extreme when you single them out.

[Spence]

Any thoughts/opinions on the Dividend Aristocrats strategy, as well? Less volatility, I would assume, given the 25+ years each stock has returned higher and higher dividends. This is a strategy I'm looking closely at.

[JimL]

Spence,

I am using that strategy as in my investment account (50% dividend stocks, 20% other stock and 30% various bonds). My 401K is all in index funds and I am fortunate to have a nice pension plan.

[Rich Uncle El]

Great Story but it lacks something. For example what was the dividend yield of Nokia when you purchased the stock? I also agree with one of the commentators as having a diversified portfolio could decrease your risk exposure. Next time you give a dividend example list more companies to compare the stock you mentioned with others.

[Barb Friedberg]

@Nick-I think the Dogs of the Dow is an interesting concept, unfortunately, some of those "dogs" are down for a reason. I hesitate to invest in any holding without individually researching the company. Although the Modern Portfolio Theory research favors investing in undervalued stocks.
@Luis-Actually, I invested in Oracle when it was a much newer company, rode it up for a 200% gain, sold most of my position and then watched the company drop significantly. The only risk free investment is treasury bills. (And then you lose out to inflation)
@Matt-A reality of investing as you obviously understand is that you can do plenty of research and still be wrong once in awhile, even with stocks you know.

[Barb Friedberg]

@Nate-Well put. And don't knock index investing. A diversified portfolio of index funds has beatend actively managed funds by large margins.
@Old Limey-Great strategy for "an older retired couple" :) As I'm sure you understand, younger folks need to increase their net worth and stock investing has been an excellent way to do so over the long haul!!!
@Tom-Excellent addition. Fortunately, Nokia was way less than 1% of my portfolio, but you drive home the point that diversification is king and ones returns should be examined in aggregate.
@Spense-I have not studied the dividend aristocrats strategy, sounds like Jim is a fan.
@Rich Uncle-I believe the dividend upon purchase was about 3.5%, still relatively high. Agreed that there is no substitute for diversification.

[Dan @ Casual Kitchen]

I'm not sure Nokia is proof of your point. Any stock--including ones that DON'T pay dividends--can go down. But with NOK you at least collected some healthy payouts in the meantime. Better that than a non-dividend paying stock that declined the same amount.

I think Mark Cuban said it best: if you have a stock that doesn't pay you some sort of yield, you're holding the investment equivalent of a baseball card.

PS: That being said: don't get tricked by NOK's current "apparent" dividend! They are almost guaranteed to cut next year's payout.

[Barb Friedberg]

@Dan-As a long long term investor. No matter how much research and investigating one does, some stocks will underperform and others will out perform. As has been said ad infinitum, that is why diversification is the only remedy. Regarding Mark Cuban, I believe in general,stocks have superior appreciation potential to baseball cards. Thank you for your thoughtful comment.

[SB]

Barb, what actually you tried saying here? should we look for dividend or not? If you are advising to invest in a high yield sock only if business potential is sound, then it does make sense.

If the article is all about not investing for dividends, then the idea and this article, both don't make a sense. I know many stocks which are consistently giving yield for decades, not years. value also is moving up, slowly but surely.

My takeaway would be to continue investing in dividend stocks and continue to follow the business to detect any signs of trouble that can affect future price.