Utilities, which tend to pay high dividends and have a regulated monopoly, meaning that they have predictable earnings and rarely lose money, were once thought of as “widow and orphan” stocks. These were stocks for those who needed steady income and could not take a substantial risk. People would give up the potential gains from growth stocks and smaller companies that could provide large capital gains in exchange for the relative safety of a steady dividend.
Companies that pay large dividends tend to be large companies late in their life cycle. They have already grown as big as they will and now have a steady business that provides a good cash flow. Because they are not growing rapidly, they are able to distribute money to investors. They are not acquiring other companies and opening new locations. Note that even if they continue to grow (Walmart and Microsoft are still expanding, for example), they are so big that they simply cannot grow at the rate of smaller companies. For example, how much more oil would Exxon need to produce to double their earnings if oil prices remained fixed?
In fact, the pricing of all stocks assumes that someday they will either start paying a dividend or be bought out by another company that will. If the company were to keep reinvesting all of their earnings in acquisitions and growth, while the company would be getting bigger and earnings would be increasing, the shareholders would never receive anything for their investment. Eventually the company is expected to reach its elder years and start to pay out a good portion of their earnings in a dividend. When buying a young stock, the price paid is actually a factor of how large the stock is expected to be, and thereby how much cash it will have for dividends, combined with how likely it is to obtain that size and how long it will take to get there.
So stocks that pay large dividends generally cannot be expected to grow significantly; however, they add stability to a portfolio and (nearly) guarantee a return even when the market is flat. Those who bought pure growth stocks during the 2000’s may have seen no return at all (at least if they bought enough to mimic the behavior of the whole market, which has been relatively flat). If they bought stocks with a 4% dividend, however, they would have at least gotten a return of 4%.
Another advantage of dividend-paying stocks is that they tend to be more stable in price. This is because as long as they are able to keep paying the dividend the yield of the stock will put an effective floor on the price. If a stock is paying $1.00 per share per year, at $10.00 per share the stock will be paying a yield of 10%. If it drops to $5 per share but the dividend remains unchanged, it will be yielding 20%. At some point, the yield will become so big that investors will come in and buy the stock simply for the dividend.
One must be careful, however, when buying stocks with outsized yields. If the business is suffering along with the share price, the company may not be able to continue paying the dividend and may need to cut it. When that happens, if people are buying the stock simply for the dividend, the stock may fall in price dramatically. When looking at stocks, make sure the earnings are substantially larger than the dividends (maybe 2 times as much) and that the company has plenty of cash flow. Also, see if their peer companies are paying comparable dividends or have cut their dividends recently if they are not.
Finally, dividend-paying stocks aren’t for everyone. When you are just starting out and have little money to invest, growth should be the primary driver. Investments should be made in stocks that are likely to grow rapidly and produce large returns. As one starts to build up a substantial net worth, however, and the focus turns from growth to stability and income, the inclusion of some high dividend paying stocks is a necessity.
Think of it this way. A portion of your portfolio should be for increasing wealth. This is the portion that is filled with growth stocks – companies that are small and growing and have great prospects for years to come. The other portion of your portfolio should be for capital preservation. This includes high-yield stocks, bonds, and mutual funds that invest in large portions of the market. These are established companies and the preferred stocks of companies. These stocks are not expected to provide a significant portion of their return in capital gains (although the price will generally tend to increase with inflation), but they will provide stability and help protect your net worth during downturns.
As time passes and your net worth grows, and as you get closer to needing the money, the growth portion as a percentage of your portfolio will decrease and the income/stability portion will increase. As you really start to need the money, some stock should be sold and converted to cash to provide even more of a cushion against downturns. I always hate to hear about people putting off retirement because of a drop in the market. With proper asset allocation, you won’t be one of them. This includes allocating a portion of your portfolio to high-yielding stocks when it makes sense. When they drop, you can sit back and collect the dividends while you wait for them to recover.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.