When markets are volatile, the prospect of a seemingly guaranteed income stream is attractive to say the least. Companies that offer dividends to their investors appear to provide just that—a steady stream of income that affirms the quality and stability of the investment. After all, a company that can afford to transfer a share of its profits to its investors must be secure, right?
Appearances can be deceiving and, as with all investments, nothing is guaranteed. Dividends can be added or repealed at any time. Share prices can rise or fall. The truth is that, as a strategy for making a profit, investing in companies that offer stock dividends works ... until it doesn't.
How Dividends Work: The Basics
Dividends are payments made to shareholders in cash or stock. Cash dividends are paid out of a company's earnings, providing shareholders with a regular quarterly income. The diversion of cash from company operations results in the company's share price dropping in an amount equivalent to the dividend paid. Investors must also pay tax on the dividends they receive.
When a company increases its number of shares, and divvies these among their existing shareholders, this is a stock dividend. As with a cash dividend, the share price will decrease to reflect the dividend payout, but the company remains free to invest all of its cash into its operations in hopes of generating higher returns. Investors can hold onto their shares to reap the possible benefits of higher returns down the road, or sell their shares for cash. Taxes are only paid if there is a cash dividend option offered.
Two Types of Companies
Generally speaking, companies that are able to offer dividends are called “value companies.” Value companies are typically large and well established in their industry. Their product market is mature and while their growth is slower, cash flow is consistent. The regularity of their operational costs and cash flows enables them to pay dividends without much risk of impacting their market position. Value companies, therefore, appear to many investors as a less risky investment.
Growth companies, on the other hand, do just that—grow. Though often smaller and less established than value companies, growth companies are the innovators, pitching a new technology or product and working towards full market penetration. Not yet mature, they invest heavily in research, development and product promotion so they have little extra cash to pay as dividends. This can make investing in growth companies appear to be the riskier choice.
Why Dividends Are Not Indefinite
The key assumption often made by investors is that because value companies are able to pay a dividend, their stock price is less likely to fall. Why? Because if shareholders need to generate money from their investments, they are, perhaps, more likely to sell their non-dividend shares in a growth company than their dividend shares in a value company. The flaw in this assumption is the belief that people will necessarily hold onto dividend shares.
The truth is that when investors panic, they will sell anything, and if an entire industry is under extreme duress, such as with the financial sector in 2008 and oil sector in 2015-2016, the decrease in the price of goods and services will drive down the cash flows of all companies operating within that sector. Eventually, even the most solid companies might be forced to cut their dividends—as most banks did in 2008—thereby nullifying the special appeal the dividend factor presented. Conversely, a growth company may do so well that its stock returns are worth more than another company’s dividends and principle growth combined.
While stocks issuing dividends can offer a welcome and relatively reliable income in times of market volatility, they cannot—and should not—be treated as safe or foolproof investments. Holding on to the perception that they are foolproof is misleading, not to mention potentially damaging to your portfolio. Bottom line: Scrutinize and manage dividend stocks within the context of your overall portfolio management strategy.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.
Stock investing involves risk including loss of principal.
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