In the equities investing risk profile, dividend stocks are considered lower-risk. There are several reasons for this. Dividend stocks are very typically representative of large, mature companies that are at or near market dominance. However, despite their understandable appeal, dividend stocks may not be enough. In fact, seemingly juicy high-dividend stocks may do more harm than good.
Dividends Are Never Promised
First off, dividends function on a more flexible payment plan than do bond interest payments. Company management can vote to increase, decrease, or even eliminate a dividend. Previous high dividend yields are immaterial for an appeal by a shareholder who would prefer dividends continue. Unlike with debt, equity investors have no automatic recourse or favor of the law when it comes to reinstating or raising a dividend. This flexibility is good for corporate finance and overall company survival, but it can throw a curveball at anyone who expects dividends to be steady.
Dividends: A Hint The Company Has Peaked
This point stems from how dividends are generated. Management has a choice regarding what to do with retained earnings and cash on hand. It can funnel such cash into profitable operations or speculative high-risk growth strategies, it can use cash to lower debt obligations, or it can reward shareholders with a per-share payout. This last option is a dividend, and though it seems appealing, keep in mind that giving cash back to shareholders is a signal that management doesn’t see a better use for that cash. Dividends can signal stagnation as much as stability. Reinvested earnings would, in theory, pump up share prices with more benefit to equity investors. Dividend distributions are a signal that there isn’t much room for growth without excessive risk to a company.
Falling Earnings and Misleading Yield
High dividend yield on the back of falling earnings and correspondingly lower share prices is a reason to worry. With a low share price, even meager dividend payout can seem attractive on a percentage basis. Imagine a company trading at $50/share and giving $0.80/share annual dividend. It then raises share price to $80/share through solid sales and maintains the same dividend. On paper, the successful company has decreased its dividend percentage from 1.6 percent to 1 percent. On the flip side, another company that has the same starting share price and dividend suffers bad earnings that sink its price to $10/share. Management can decide to keep the same dividend, offering a seemingly-generous 8 percent dividend yield even though this second hypothetical company is in far worse shape than the first, successful corporation. The lesson is that one should not chase yield without looking at company fundamentals and its position in the marketplace. Dividend-chasing can land you into a trap that gives losses as the underlying company sinks into the red and inevitably cuts its dividend, leaving the investor with a cheaper stock and no dividend to soften the loss.
Of course a discussion on dividends does not end here. Interest rates, debt, market disruptors and more can make or break dividend investors. However, generally speaking, high dividends alone are not enough to guarantee gains or an income stream. Dividends are under no obligation to continue for any length of time into the future, they can signal company stagnation more so than stability, and can seem deceptively attractive as company fundamentals erode while oblivious shareholders buy into seemingly-stellar dividend yields. Growth stocks, bonds, commodities, even derivatives can play a role in securing overall gains that are not at the whim of deceptive high dividends.