3 Dangers of Chasing Dividends

June 28, 2018

Are you chasing dividends?

I recently reviewed the investment allocation of someone whose broker had passed away. Almost all of the stocks she owned were in older, “name-brand” companies that paid a dividend.

At first glance, these were household names that everyone knows, which certainly doesn’t sound all that bad.

But a deeper dive into her investments showed me that these were also all companies with very little (or no) recent growth, and whose most-profitable years were decades in the past.

With all the options available to investors—and with diversification an integral component of almost any well-constructed portfolio—why would someone invest in once-famous companies that haven’t grown in years?

Here are five reasons:

There’s prestige in owning a company that your grandmother would have been proud to work for.
Some investors over emphasize an “income approach” to investing (at the expense of pursuing overall returns).
She purchased these companies through her broker who received a big commission for each transaction.
We’re still in a low-interest rate environment, so stagnate returns on traditionally “safer” investments (such as bonds) have convinced some people that their only option is to chase dividends.
Many investors believe that any company that pays a dividend must be financially stable.

Unfortunately for this investor, once I analyzed each company she owned, I found that, not only was she paying a premium price per share (based on earnings), but because the best days of these entities seemed to be so far in the past, their future viability actually came into question.

Chasing dividends, (something I often see with people who work with commission-only brokers), is, in my experience, a too narrow and too risky approach to investing.

So, with that in mind, what are some of the other dangers of chasing dividends?

Here are three examples:

1) Stock dividends are not guaranteed

It’s not impossible, even with the scenario above, that a person could invest heavily in a strong brand—for a sense of security, likely—and for that company to suddenly stop paying a dividend.

That’s because, much to the surprise of many investors, dividend payouts are entirely at the discretion of companies. They are not guaranteed.

Take the West Coast utility Pacific Gas and Electric (PG&E), for example.

Founded well over 100 years ago, and once America’s largest utility company, in the wake of California’s devastating October 2017 Wine Country wildfires, PG&E suddenly suspended dividend payouts to shareholders in the 4^th quarter of last year. ^[1]

2) Dividends are sometimes paid merely to attract new investment

Some world famous companies likely continue to pay out strategically calculated dividends for no better reason than to keep long-term investors in the fold, many of whom automatically reinvest their dividends and buy more company stock.

Another reason companies might pay dividends, even when earnings are low, is to attract dividend-chasing new investors who are seeking income-generating investments, or who want to invest in the seemingly “safe” haven of a well-known brand.

Both of these practices, along with our current bull market, are likely artificially elevating stocks across a variety of sectors.

3) Dividend yield is not a great assessment tool

Dividend yield shows how much a company pays out in dividends each year relative to its share price. It’s a way of measuring how much cash you might get for every dollar invested.

Some people cite a company’s dividend yield as a prime indicator of whether a stock offers value.

That’s not a good approach. Here’s why: Dividend yield is just a ratio (the current dividend amount divided by price). It is, in essence, a superficial indicator that doesn’t really tell you anything about the underlying strength of a company.

For instance, there are companies whose dividend yield remained unchanged while their investors lost as much as 45% of the principal of their stock in a single year.^[2]

Conclusion

I’m not a fan of chasing dividends.

Before purchasing the stock of any company, you should consult with a credentialed, fiduciary advisor to thoroughly evaluate earnings, and to determine if said company is paying dividends for the right reasons.

That’s because, in the long run, earnings are a far better indicator of a company’s health than high dividends. And the fact of the matter is that I’d rather own a company that turns a nice profit and pays no dividend, than own a company that is paying out more than it’s making.

[1] https://en.wikipedia.org/wiki/Pacific_Gas_and_Electric_Company

[2] https://www.investopedia.com/articles/investing/082015/3-biggest-misconceptions-dividend-stocks.asp

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