The high dividend stock strategy is like many other strategies in that it appears to be straightforward but contains some hidden risks. If one is to adopt this strategy, then it must be selected with an understanding and a plan. Otherwise, it just becomes just another shiny object one reaches for but never seems to catch. This article offers an understanding of the inherent problems with the strategy and seeks to find ways to overcome them.
The power of dividend investing is based upon the reduction of risk, which leads to the preservation of capital. By deciding not to chase fantasy returns, one can move forward in a world where others move their feet without going much anywhere.
"Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else—if you run very fast for a long time, as we've been doing."
"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"
Lewis Carroll - Through the Looking-Glass and What Alice Found There, Chapter 2
It appears to be a contradiction to both to mitigate and increase risk, though that is what I have done for a long time with my InvestMete Strategy. If one understands the risks inherent with a strategy and has a plan to deal with them, then a dividend investing strategy can be moved to the next level of returns.
The dividend yield is the percentage of the share price that is returned to the shareholder. The higher the yield, the more the shareholder receives. One might think that the strategy should be to seek out high dividend stocks so that they receive the highest dividends possible. Were that the end of the story, this would also be the end of the article.
Hartford Mutual Funds found that "stocks offering the highest level of dividend payouts have not performed as well as those that pay high, but not the very highest, levels of dividends.” Wellington Management divided companies into five groups based upon dividend payout.
The number above each of the five groups indicates the percentage of time the group outperformed the S&P 500 Index during the study’s time period. High dividend companies did better than low dividend companies, but the highest dividend yielders were not the best – the second-highest group was the best. Chasing those with the biggest promises did not deliver as well as those who offer slightly less.
Additionally, high risk does not always equate with high reward, as noted in Alpha and Beta. In 1972 Merton Miller and Myron Scholes showed that high beta stocks underperformed low beta stocks. Simply because one decides to take on an additional set of risks, they are not necessarily rewarded for their efforts.
This is a real problem. One who blindly jumps into high dividend companies without regard to understanding these facts and without a plan is starting at a disadvantage and may have to run as fast as they can to stay in place.
How this could happen is clear. Unlike Treasury bonds or a savings account, dividends are not guaranteed. The company can offer an enticing dividend one day, then make the decision not to pay that it, or pay a smaller amount a subsequent day.
In the article Learning from Dividend Reductions I talked about Codorus Valley Bancorp’s decision to cut their dividend by 37.5% after having raised it each of the past nine years. The pandemic apparently reduced their earnings to the point where they felt that it was in the best interest of the company to offer a smaller percentage of their profits to their shareholders.
A high dividend yield can be a warning sign that may signal a problem. If company XYZ is valued at $100 and offers a 3% dividend yield, and, for whatever reason, its share price drops to $50, the dividend yield doubles to 6%. That would be an attractive yield, but it would be required that one understand why the price dropped before making a purchase decision.
Before we make a plan, we need to figure out exactly what defines a company as having a high dividend. There is no actual number that can be used for this. Part of the reason is that the average dividend yield of the market is not consistent. At the end of 2019, the average dividend yield for the S&P 500 was 1.83%. If one were to double that (3.66%) then that would equal the average dividend yield at the end of 1987. Double that again, and it is less than the average at the end of 1950.
For our purposes, I will suggest that a high dividend company offers a dividend yield of 50% higher than the average. Of course, a reasonable follow-up question is, "the average of what?" I will come to that in just a moment.
The payout ratio defines the cost of the dividend to the company. The payout ratio is the percentage of the profits that are returned to the shareholders. Think of it as a discretionary line item in your budget. While you cannot get away from the mortgage or rent and have to pay the electric bill each month, the money allotted to purchase the expensive coffee might need to be reduced when other expenses eat into your budget.
In the case of the aforementioned Codorus Valley Bancorp, the company had traditionally set aside about a third of the profits for dividends. When their profits declined, the amount scheduled to go to their shareholders increased as a percentage of their profits to the point where they were no longer comfortable offering the dividend, so it became a casualty.
A payout ratio that approaches 100% means that almost all of the profits will go to the owners, without leaving a sufficient amount to cover things that the company requires. Although some companies have allowed this percentage to approach and even exceed 100%, this is not something that any company can maintain for long.
A company's history offers insight into how the company is run and how important it considers the dividend to be. The Dividend Yield and Stock Price Connection explains the connection between stock price and dividend yield, so it is in the interest of the company to maintain and increase the dividend regularly.
The best source for finding companies with a long history of increasing dividends can be found in the Dividend Champions spreadsheet. Companies that have increased their dividend for at least five, ten and twenty-five years are listed in separate worksheets, along with information that can help with one’s due diligence.
The list of Dividend Champions, which have provided their increases over the longest period of time, rarely cut their dividend. It does happen. In the 2008-2009 period, when we experienced the Great Recession, 30 of these companies cut their dividends. It should be noted that only one of these actually suspended their dividend, and more than half of them have increased their dividend over at least the past five years.
During the pandemic, six companies cut their dividends. As I noted in Safety and the Dividend Champions, my opinion is that one company (Calvin B. Taylor Bankshares) should not be included in that list.
Outside of these two unusual events, only four Dividend Champions have reduced their dividends over the past dozen years, and one of these cut following a sale, so it depends upon how one wishes to define "Dividend Champion" as to whether or not it should be included. The bottom line is that Dividend Champions are as safe as one can get when it comes to staying away from a dividend cut.
Seeking companies with a long dividend history, a reasonable payout ratio, and high dividend ratios are the primary components of the High Dividend Strategy. To begin the screening process, we should use the Dividend Champions as a starting point, as they have already been shown to have a very successful and long career at maintaining and increasing their dividend.
The average dividend yield of the 140+ Dividend Champion companies is 2.93%, so we use the spreadsheet to identify companies that offer dividend yields that are 50% higher than the average, or 4.4%. 21 companies offer such dividend yields.
It is scary to see that nine of these companies have dividend payout ratios over 100%. Nevertheless, this group of companies sees a continuing dividend as exceptionally important to their business model. ExxonMobil and Walgreens are actually over 200%. This indicates that these companies will need to go into debt to pay their dividend, which is something that can happen, but if done too long, can burden a company with debt.
Some companies show "n/a" in the EPS% Payout column, which is where we find the payout ratio. I asked Justin about that, and he told me that this was probably because the company reported negative TTM GAAP earnings, which is used to calculate the payout ratio. You can enter “Chevron payout ratio” to get this information for the few companies where this information is missing.
Nine companies show payout ratios under 75%, so that is a good place to start. Blindly selecting a company from this group can lead one into danger, so this is where one looks at the business model, the company history, and meaningful financial metrics that allow one to make an informed decision.
Despite finding a proper company for purchase, it is important to ensure that the company fits one's portfolio. Of the nine companies that pass the screen suggested above, seven are in the Financial sector. One does not want to place too much weight on one sector. After all, if one were to load up on financial stocks followed by another Great Recession, the portfolio would be subject to an overweighting of bad news.
If no acceptable companies are to be found within the Dividend Champions, then Dividend Contenders offer a listing of companies that have increased their dividend over the past decade. This timeline does not include the Great Recession, which means that company history during that time needs to be researched. The example of Codorus Valley Bancorp would have been instructive to understand how the company reacted under those circumstances.
The High Dividend Strategy can help charge one’s dividend portfolio if the risks are understood, and a plan is formulated to deal with those risks.