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Sound Advice: June 5, 2024

What You Need To Know About Dividend Stocks

At first glance, the appeal of stocks paying generous dividends is the sense that there will be a dependable flow of income while holding them.  Well, as you might suspect, there’s a lot more to think about before buying.

Stocks that pay generous dividends are typically those of mature companies with moderately growing profits.  When dividend yields are above average, the price-earnings ratios are usually low, i.e., their valuations relative to ongoing gains are relatively low. The reason for the low valuations is that investors do not expect the rate of yearly progress to change much.

The polar opposite of dividend stocks (which are also known as value stocks) are high growth companies that offer little or no payout with their shares. 

If all dividend stocks and high growth stocks would perform in line with expectations, the high growth stocks as a group would outperform the dividend stocks.  But the actual results over time show the exact opposite result. 

How can this be?

The reason is that there are always a few members of the high growth group that turn in disappointing results, which inevitably causes investors to bail out, often dropping the stock’s price by precipitous amounts. So even though most of these stocks will do well, the drag caused by the laggards will weigh heavily on the average of all held.

The opposite takes place with dividend stocks.  Not-so-hot news has already been built into current prices, so as more of the same is announced, there’s not likely to be much impact.  But when these companies report larger than expected upside surprises, they will jump.  And those jumps will tend to raise the average returns of the group about those of the high growth companies.

To take advantage of this apparent anomaly, it is essential to buy groups of at least two dozen of the dividend stocks. Always ensure that the dividends being paid are comfortably covered by the current level of earnings.

This approach will not work in every year, but over time it should be worthwhile.

These findings are based on a 20-year study of the Standard & Poor’s 500 in which we divided the universe into 10 deciles (50 stocks each) from lowest to highest dividend yields.  The highest long-term returns were from the group of highest dividend paying stocks. Returns descended in perfect order from highest dividends to lowest dividends.

A similar study divided the S&P universe in 10 deciles from lowest to highest price-earnings ratios. Although not in perfect order, the returns were highest for the stocks with the lowest price-earnings ratios and lowest for those with the high price-earnings ratios.

Each of the exchange-traded funds holding high dividend stocks that may be worthy of consideration should have at least two to three dozen holdings.  A variant from Vanguard, VIG, simplifies that approach by holding what appears to be the top third of dividend payers in the S&P universe. That ETF might be viewed as a hybrid market index fund rather than a high dividend vehicle.

N. Russell Wayne

Weston, CT

Any questions: please contact me at nrwayne@soundasset.com

203-895-8877

www.soundasset.blogspot.com

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