Are Dividend Stocks Good Investments?

Here's a piece from the Wall Street Journal that can be summarized as follows:

• Bonds (and other forms of income-generating investments) are yielding very low rates. Duh!


• As a result, Americans are plowing a ton of money in high-dividend stocks and mutual funds.


• While doing this can result in a better yield for those needing income, it also comes with extra risks (mainly, the underlying assets can lost their value.)

In other words, a dividend-paying stock isn't the same thing as a bond -- in many different ways.

Given the above, the WSJ suggest four tips for investing in high-dividend stocks and mutual funds as follows:

• Diversify your income sources. To limit stock-related risk and boost income, plan to get income from a mix of bonds, as well as dividend-paying stocks.


• Own some stocks just for growth. Most investors—even those who already have entered retirement—need the capital appreciation that stocks can generate to reduce the risk of outliving their assets.


• Be mindful of fund costs.


• Be sure you're comfortable with overseas exposure. One classic strategy for income-oriented investors—and the funds that cater to them—has been to blend U.S. stocks with European stocks, since the latter historically have had higher yields.

These seem like pretty common sense tips to me. Of course you would never want to put all your eggs in one basket -- especially one that's low on growth, expensive, and subject to either default or large drops.

But what if you found a group of stocks that had lots of room for appreciation, were relatively safe, and had high yields? Something like maybe the Dogs of the Dow?

For those of you not familiar with the Dogs strategy, here's the (edited a bit) take from Wikipedia:

The Dogs of the Dow is an investment strategy popularized by Michael B. O'Higgins, in 1991 which proposes that an investor annually select for investment the ten Dow Jones Industrial Average stocks whose dividend is the highest fraction of their price.

Proponents of the Dogs of the Dow strategy argue that blue chip companies do not alter their dividend to reflect trading conditions and, therefore, the dividend is a measure of the average worth of the company; the stock price, in contrast, fluctuates through the business cycle. This should mean that companies with a high yield, with high dividend relative to price, are near the bottom of their business cycle and are likely to see their stock price increase faster than low yield companies. Under this model, an investor annually reinvesting in high-yield companies should out-perform the overall market.

The logic behind this is that a high dividend yield suggests both that the stock is oversold and that management believes in its company's prospects and is willing to back that up by paying out a relatively high dividend. Investors are thereby hoping to benefit from both above average stock price gains as well as a relatively high quarterly dividend.

In other words, on January 1 you buy the top 10 Dow stocks with the highest yield. You hold them for a year and rebalance (sell those off the next year's list and buy new ones on the list) each January 1. Supposedly, this will net you a better TOTAL (appreciation plus dividends) return. Whether or not this actually happens is up for debate.

And in case you were wondering, here are the Dogs for 2012:

• AT&T
• Verizon
• Merck
• Pfizer
• GE
• DuPont
• Johnson and Johnson
• Intel
• Procter and Gamble
• Kraft

The highest of these yields 5.82% and the lowest yields 3.1% (as of the beginning of the year), well better than you can do with many other income-producing assets PLUS these stocks are "supposed to" appreciate. Whether or not they actually do/will is again up for debate.

I must admit that this strategy would tempt me if I needed income (like during retirement.) But I'd have to do a lot more research (and develop an overall investing plan) before I decided whether or not to jump in with the Dogs.

We know that one FMF guest poster hates dividend investing, what about you? What's your take on investing in high-dividend stocks/mutual funds and/or the Dogs of the Dow strategy?

Comments

[retirebyforty]

I like dividend stocks and 5.82% yield is nothing to sneeze at. If I can get 5% from bonds or CD, I would increase my allocation there. Good tip about European stocks, I have Royal Dutch Shell, but probably need more.

[Steve Mertz]

I think the Dogs of the Dow is a pretty weak way to make investments-we're talking about such a limited piece of the stock universe! I like some dividend paying stocks such as KMP. I purchased it on 1-20-2011 for$71.91 and to date it's up 24+% and I sleep well!

[Bad_Brad]

In this low interest rate environment, I keep hearing all about how high dividend stocks are a "safe" place to chase a higher yield. It's an epidemic, and it needs to stop. Fixed income investments and high dividend stocks are apples and oranges. And there is no such thing as a "safe" stock with a high dividend yield. The market is pretty efficient, and if a company has a high dividend yield, there are probably valid reasons why. It's not like you're the only one in the world who realizes that a company's dividend yield is high.

[Old Limey]

I have been retired 20 years, have plenty of income and hold many bonds in our IRAs and also in our children's IRAs that I manage. What I like about them is that regardless of the gyrations of the stockmarket they always return the same amount of interest every year.

Three examples are:
G. E. Capital 5.70% coupon, maturing in 2024
Goldman Sachs 5.50% coupon, maturing in 2032
Traveller's Insce. 5.35% coupon, maturing in 2040

I also have CDs yielding 5.15%, maturing in 2015

I particularly like it that the income is all tax deferred and that, regardless of fluctuations in the bond values, at maturity they will pay back $1,000 per bond, which is what I paid for them.

We also plan on leaving our IRAs to our children and they then become "stretch" IRAs because the children are naturally much younger and will be able to stretch out the mandatory required distributions a lot long than we will because their distributions will be a function of their ages and not our ages.

Unlike dividend stocks, these interest rates are set and cannot be changed.

[Jclimber]

@Old Limey - where do you buy your bonds? Thanks!

[jim]

I agree with Brad that dividend paying stocks are not especially 'safe'. Stocks are not save and dividends are not guaranteed. They should not be treated as equal to bonds or thought of as 'safe' in general.

And worst case someone might chase dividends blindly and end up with a stock that is risky in nature. Sometimes dividends are high short term if a company's stock is diving due to current problems and the company hasn't yet cut the dividend. e.g. some of the banks had very high dividends during the financial crash... at least until they slashed their dividends.

I do generally like dividend paying stocks and I've done fairly well investing in them in the past few years. But its just not a replacement for fixed income in my mind. Picking a handful of dividend stocks is not much different than picking a handful of other stocks.

The Dogs of the Dow is a neat idea. But its performance is up and down and long term doesn't seem any better than the Dow as a whole.
The Dogs of the Dow did worse than the Dow Jones or the S&P 500 in 2007, 2008 and 2009.
If you bought the dogs in 2007 and held it 3 years then by the end of 2009 you'd be down 27%. The DOw as a whole would only have been down 9% in those 3 years.
20 year cumulative performance of the Dogs is the same as the Dow.

[JimL]

I think the dogs of the Dow are a good piece of a larger stock portfolio. When buying bonds, it is better to buy specific bonds like Old Limey does and not bond funds. The bond funds are likely to drops when rates rise. If you buy bonds directly and rates rise, you will only lose value if you sell before maturity.

[Blair]

Rather than taking dividends as income, I am a big fan of re-investing dividends.

[Old Limey]

@Jclimber
You need to have an open account containing the money that you intend using to buy bonds. I have been a Fidelity customer since 1992. I go to their website, click on "Research", then on "Fixed Income", then on "Find Bonds and CDs". I have never asked Fidelity to help me select investments, I like to do it all on my own

They have more than 30,000 New Issue and Secondary market offerings. The secondary market is only open during bond market hours. The ones I generally look at are Muni Bonds (secondary market), Investment grade bonds (secondary market), and the Corporate Notes program. I bought some new issues in 2007 but these days the new issues have unattractive yields so I never look at them.

There is also a way provided by which you can create screens for the type of bonds you are looking for in terms of price, maturity, yield, Moody and S&P ratings etc. and then save the screens for future use. I taught myself how to use it and have been buying bonds since late 2007. Muni bonds are tax exempt on your Federal return but on your State return out-of-state muni bonds are taxable. The search screen displays the results for what it finds and you can sort the data by whichever column you are interested in. I have 92 groups of muni bonds, 21 groups of investment grade bonds and 20 CDs, all purchased at Fidelity's website.

The minimum number of bonds that you can buy is 5 (i.e. $5,000), often in the secondary market some sellers will only sell larger quantities. I also reinvest all of the dividends. Muni bonds pay dividends every 6 months, so if you have as many as I do then you will get interest every month, usually some pay on the 1st. and others on the 15th.

[M]

Old Limey -
If you're buying on the 2ndary market, do you do sorts/buy on the face rate, or yield to maturity?

[Old Limey]

@M
I rank the output from my screen by "Yield to maturity" since that is most important to me, then if possible I prefer a bond issued by my own state, I also take the ratings into consideration. I also don't buy bonds that are very much over par value. The average yield on my 3255 bonds is 4.9886% and the weighted average bond price is $983.8 so I also make small capital gains as they mature or are called.

[Apex]

I agree with Brad and jim. Dividend stocks are not a "safe yield investment" and Dogs of the DOW contains no magic nor any hidden safety. Sometimes a stocks yield is high because it is undervalued. Sometimes it is high because the stock and company are in trouble and they haven't lowered the yield yet. You buy the stock, they lower the dividend dramatically and then the stock tanks another 30%.

Ah but does that really happen? It happened to nearly every bank stock out there in 2008 and 2009. If you simply follow the high yield strategy you will get some undervalued winners and some over-valued losers that are going to go down in value and slash the dividend dramatically.

There is no yield safe stock investment.

[Jclimber]

@Old Limey - thanks for the tips! I have a Fidelity account so I'll check out the bond offerings there.