I like dividend paying stocks and have been writing about their virtues since early 2009, well before they became the rage on Wall Street. \u00a0I like them for a few reasons.\u00a0 \u00a0Most large, mature U.S. companies can pay a decent dividend without hurting their EPS growth, so it enhances investors\u2019 total return. \u00a0Unlike share buy-backs, dividends continue to be paid during recessions, generating cash that can be invested in stocks when they are cheap.\u00a0 Dividends impose more financial discipline on corporate managements than share buy-backs because they have to be paid every quarter and are far more transparent.\u00a0 Unlike dividends, buy-backs \u00a0can be announced but not executed, or executed but offset by issuance for acquisitions or employee stock options, so the share count does not actually decline.\u00a0 Finally, dividends are convenient; investors don\u2019t need to decide when to sell shares.<\/p>\n
But these virtues must be kept in perspective.\u00a0 Using dividends as the primary<\/strong> stock-picking criterion is a good way to lose money<\/strong>.\u00a0 The value of a company is determined not<\/strong> by its payout policy but by its fundamentals \u2013\u00a0 its ability to earn returns above its cost of capital and to generate free cash flow.\u00a0 Dividends are not necessarily a good indicator of these fundamentals.\u00a0 Many companies with poor fundamentals can afford to pay high dividends, at least for a while.\u00a0 Indeed, some firms, including quite a few utilities, are effectively financing their dividends not with internally generated funds, but rather by issuing new shares.\u00a0 High yields can be particularly deceptive, because they are lagging indicators.\u00a0 When the fundamentals of a company are deteriorating (think GE in 2008), corporate boards of directors are the last to know; as the stock price slides the dividend yield will rise, enticing nvestors\u00a0 until the board wakes up and belatedly slashes the dividend (think GE in 2009).<\/p>\n One good example of the risk that comes from putting the dividend cart before the fundamentals horse is Standard & Poor\u2019s \u201cdividend aristocrats\u201d \u2013 51 stocks in the S&P 500 that have raised their dividend every year for at least the last 25 years.\u00a0 Specifically:<\/p>\n Bottom line:\u00a0 It is a mistake to simply invest in the Dividend Aristocrats Index (or an approximation thereof), because you will own too many weak, slow-growing companies while systematically avoiding attractive areas such as technology and banks.\u00a0 It makes more sense to use the Aristocrats as a \u201cshopping list,\u201d favoring those stocks that have fairly strong dividend and earnings growth, positive stock price momentum, dividend payout ratios below 60%, and rising consensus EPS estimates.\u00a0 To these should be added quite a few non-Aristocrats with strong fundamentals, decent yields of 2-4%, and rising dividends.<\/p>\n The Aristocrats\u2019 defenders may protest that they have tended to beat the market over time.\u00a0 Perhaps so, but keep in mind that recently the market has favored stocks that pay dividends and are in defensive sectors, such as consumer staples.\u00a0 Stocks fitting that description (including many aristocrats) have become fairly expensive and may not continue to outperform, particularly if their fundamentals are lackluster.\u00a0 The boilerplate caveat, \u201cPast performance is not an indicator of future results\u201d is definitely relevant here.<\/p>\n","protected":false},"excerpt":{"rendered":" I like dividend paying stocks and have been writing about their virtues since early 2009, well before they became the rage on Wall Street. \u00a0I like them for a few reasons.\u00a0 \u00a0Most large, mature U.S. companies can pay a decent … Continue reading \n