Dividend Stocks: Illusions and Misconceptions

Dividend Stocks: Illusions and Misconceptions

Many new investors jump in the ship with the knowledge that dividend stocks are safe investments. Even seasoned investors reserve some spots for dividend stocks in their portfolios. This is because dividend stocks are generally more reliable than growth stocks and other stocks that don’t pay a dividend. However, dividend stocks aren’t all that silent and dull. They’re not as clean as we think they are. If you know how dividend stocks work, you should also know how they don’t work. Below are the biggest dividend stock illusions. Check them out!

Dividend Stocks Illusions and Misconceptions Infographics

Illusion #1 High Yielding Dividend Stocks are the Best

This one’s very common among investors: they think that a high yield is always a good thing. A lot of investors choose a set of the highest dividend paying stock and hope for the best. There are many things that make this belief wrong. It’s not always a good idea.

Keep in mind that a dividend is a percentage of a business’ profits. The company pays it to its owners, or shareholders, in the form of cash. The cash that they pay in a dividend is not reinvested in the business. So, if the business is paying you a very high percentage of its profits, it may mean that the company doesn’t have many other opportunities to grow through reinvestments. The company may also not have much upside.

The dividend payout ratio measures the percentage of profits that the business gives the shareholders. It goes without saying that you can use it as a metric to see if the dividend payer is still capable of reinvesting and thus growing.

High yielding dividend stocks with a low payout ratio (below 52 percent, which is the market average) typically offer a high return. Dividend stocks as a group have endured major economic crashes and have survived the market in good and bad times.

Low payout dividend stocks, surprisingly, do better. According to a report that tracked stock returns from 1990 to 2008, high yielding dividend stocks with low payout ratios beat all other variations of yield and payout. They also more than doubled the S&P 500’s return.

Learn about the illusions and misconceptions about dividend stocks!

Illusion #2 Dividend Stocks are Boring

When we speak of high dividend payers, we automatically think of utility companies and other slow-growth businesses. This is because investors frequently focus on the highest yielding stocks.

Here’s what we tell you, dividend stocks can be much more exciting. That is, if you lower the importance of yield.

Dividend stocks can have the potential to raise its dividend if the yield at present is low. When the dividends are raised tremendously, the company’s stock price ups. This rise is actually a great start on a total return. We can check out several indicators to help us predict whether a dividend stock will go up in the future or not.

·         Financial Flexibility

This is a no-brainer. If a stock has low dividend payout ratio, it practically means that it can raise its dividend. Two other good things are if it has low capex and debt levels. However, once the company is taking out debt just to maintain its dividend, you must begin to be wary. That’s an ominous sign.

·         Organic Growth

You may also look at a company’s earnings growth. In addition, you have to be on the lookout for cash flow and revenues. If the company grows organically, increases foot traffic, sales, and margins, then it’s likely that it will increase the dividends. On the other hand, if the business is simply boosting its earnings by cutting costs, it decreases the chance that you’ll receive a healthy dividend.

We can look at Walt Disney as an example. It has never appeared to be a high yielding stock. Nowadays, it yields only 1.23 percent. However, its dividend has already risen a staggering 19 percent annually over the past half decade. This matches its EPS growth.

You may think that the yield still seems low, but that’s just because the stock price has increased four times its original price over the past five years. The shareholders who bought Disney stocks five years ago see their dividend yields at around 4 percent.

This is just one of the various reasons why limiting your dividend selections to growth stocks, with low payout ratios and good future growth prospects, is actually a good idea. It’s another rule when it comes to careful stocks selection.

Read more about picking stocks! Read Picking Stocks: 4 Things to Consider

Illusion #3 Dividend Stocks Are Always Safe

If companies paid dividends only when they were performing great, dividends may be really “safe” all the time. However, that’s not what happens in real life.

A dividend payment is usually a tool to placate frustrated investors when a stock is not moving. A huge number of companies increased their dividend payments as their businesses became more competitive.

For instance, Best Buy Co Inc has already raised its dividends a number of times. It did that even though Amazon.com Inc has bullied it into a price war, which has killed margins.

Another example is Radio Shack, which raised its dividend in spite of its already seeming demise.

For some possible reasons, these dividend payment hikes managed to subdue some investors. And the companies did these even if it means compromising their chances for a longer term survival.

For you to avoid these kinds of dividend traps, always try to know whether the management pays dividends for the right reasons. It’s obvious that you should avoid dividend payments that serve as consolations for investors. They give out such payments to compensate for the lack of growth.

Certain dividend stocks are sometimes value traps.
Certain dividend stocks are sometimes value traps.

Moreover, if a yield has popped up because of a crippled stock price, find out why before you purchase that stock. Back in 2008, many financial dividend yields rose artificially high because of stock price slides. For investors during that time, those dividend yields appeared tempting. However, when the financial crises came to full effect, profits dropped. Numerous dividend programs stopped. The halts in dividend programs typically cause stock shares to decline.

Not sure which investments are safe? Read: Low Risk Investments

Other Misconceptions

There are other illusions or misconceptions that you should avoid. Additionally, there are things that investors usually do not get right about dividends.

Sadly, many misconceptions and illusions about dividends come from financial advisers. For instance, many advisers tell clients that dividends don’t count towards a stock’s gains or losses.

According to a recent academic paper, considered a breakthrough, called “The Dividend Disconnect,” such assumptions are simply untrue.

Professors Samuel Hartzmark and David Solomon wrote the academic paper. They discovered that many illusions and misconceptions about dividends come from the so-called “free dividend fallacy.”

The “free dividend fallacy” posits that a big number of investors see dividends in isolation. They ignore  the symbiotic correlation of dividends with capital gains and losses. The two professors argue that such elements must go in tandem, rather than separately.

Paradigm Shift

If we are to follow the authors Hartzmark and Solomon, the problem with dividends is the investors’ view of them. How do most investors view them? They view dividends in isolation from capital gains.

The unfortunate truth is that investors see dividends as “extra” income coming from a fund’s performance. And because of this, investors tend to ignore fundamental rules about the dividends’ impact on a fund’s performance.

For instance, right after the company pays dividends, its stock price usually slips. Why? Because there’s a direct shift of money from the stock price to the dividend. However, because investors view dividends separately from stock price, they forget to compute this transfer.

Basically, investors can profit from selling the shares of a stock as they could from getting dividend payments. This is due to the fact that a dividend functions very similarly to selling shares. The stock gets devalued upon payment.

Read also: Differences Between Fundamental And Technical Analysis

Accounting

If you think that the “free dividend” mindset is a mere case of erroneous accounting, you got it. In the case of dividends, experts generally agree that the problem is mostly psychological.

Hartzmark and Solomon discovered that respondents put their dividend payments in a separate mental bank account. By separate, we mean from the stocks to which they were tied. This indicates that they treat dividend payments as a separate income stream, like other income-generating instruments.

Additionally, the aforementioned authors found that interest rates created a hot market for dividend-paying stocks. On the other hand, as investors go for dividends, they inflate prices. They ultimately lower the rates of return. And because of all this popularity, dividend-paying stocks become expensive and, more often than not, overvalued.

What to do?

If you find yourself doing those same things, it’s time for you to change habits. Keep in mind that a stock price’s downward spiral can undermine generous dividends. Follow the advice of Hartzmark and Solomon even if it seems counterintuitive.

Curious about rebalancing?  Read Portfolio Rebalancing: When and How it Should be Done

Final Word

Overall, the most important thing to do is to analyze dividend stocks like any other stocks. Look into the quality of the business. Check its best future earnings potential. Doing those things will likely give you the stocks that can raise their dividends. And such a rise should pave the way to a higher stock price and total return. Don’t expect a good return if you only look for high yielding stocks. Avoid basing your judgment on the illusion that they are always safe. Find a great business first.

 

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