Whether it’s through stocks or funds, investors seeking that income exposure must keep some things in mind
Last year, many investors were caught unaware as watched their portfolio gains get swept away by market turbulence. And with fresh indicators pointing to slowing economic growth, expectations for healthy capital gains have become that much weaker.
That has spelled a renewed interest in defensive securities, including dividend stocks. Offering steady income alongside the potential for capital gains, dividend stocks tend to be issued by companies with strong balance sheets. On top of that, they’re less volatile than non-dividend-paying equities.
And according to the Wall Street Journal, the changing trajectory of interest rates is adding to dividend stocks’ appeal. In a rising-rate regime, bonds become more attractive to income seekers as their yields get pushed higher. But as rate hikes decelerate, dividends become comparatively attractive. And evidence from research indicates that over longer periods of time, dividend stocks are often able to outperform their non-paying counterparts.
But investors should be judicious in choosing dividend stocks. Extremely high dividend yields, for example, are often a sign of a company in trouble: since yield is obtained by dividing the annual dividend by the current stock price, one could arrive at a high yield through a plunge in a company’s share price.
“High dividend yields often reflect that the dividend is uncertain and may be cut,” retired hedge-fund manager Chris Litchfield told the Journal. He advised investors to be wary of companies that offer a 6% yield or higher.
Another danger comes from companies funnelling too much capital into dividends, which could mean not enough is being reinvested in the business; Litchfield said dividend payouts should account for less than 80% of net income. And according to Michael Sheldon, chief investment officer at RDM Financial Group-HighTower, companies that initiate or raise their dividends have historically outperformed other stocks — while having lower volatility.
When considering mutual funds and ETFs with dividend tilts, investors should be mindful of the sectors a fund focuses on. “Sometimes funds load up on energy stocks, and you’re taking on risk if oil prices drop,” said David Carter, chief investment officer at wealth-management firm Lenox Wealth Advisors.
Cyclical stocks such as manufacturing companies are also not likely to do well in low-interest-rate situations, noted Jack Ablin, chief investment officer at Cresset Wealth Advisors. In a time of economic weakness, he said, defensive companies like consumer staples make more sense.
Another consideration, at least for the ethically minded investor, is whether companies with large dividends are crossing lines they shouldn’t. As an example, banks that promise large dividends may be able to deliver in good times, but when the economy stalls and the pressure to keep shareholders satisfied builds, they could end up pushing their tellers and advisors into using aggressive and questionable tactics.