I have been reading a lot about what types of investments are good to hold in a recession. While no one investment is bulletproof, we do see experts claiming that some products are better than others.
Amongst the products are consumer staple stocks, healthcare stocks, investment-grade bonds, and dividend stocks. Today I thought I’d address the latter – dividend-paying stocks.
What are some of their characteristics?
There’s a popular perception that “dividend stocks”—i.e., stocks with a reputation for paying out consistent dividends—can deliver decent returns, while also creating a dependable income stream for spending in retirement or elsewhere.
But is stocking up on dividend stocks really such a good idea? Building a large position in dividend stocks may appeal at a glance, but a closer look reveals several cracks in the foundation. Today, I’ll describe how dividend stocks actually work. Then, I will address if they make sense in recessions, or just generally in a globally diversified investment portfolio.
More Dividends = Less Capital
Perhaps the greatest misperception about stock dividends is that they represent “free” or “extra” money, above and beyond the capital value of the shares you hold. This free-dividend fallacy leads investors to think of stocks as their cake, and dividends as an extra layer of frosting.
That’s not how it works. As University of Chicago’s Samuel Hartzmark explains:
“If you have a stock that is worth $10 and it pays a dollar worth of dividend, the price goes to $9, and you’ve got a dollar worth of dividend. So, unlike the bond where, if it paid a certain coupon payment, you end up with more money, when you receive a dividend, you have the exact same amount of money, just labeled slightly differently.”
In other words, dividends are a bite out of your cake. You might not notice a specific dividend-driven price drop, since market pricing mechanisms are always instantaneously adjusting share prices based on myriad factors. But it’s there. Post-dividend, your stock—your slice of a company—is worth a tiny bit less.
This makes sense. After a company distributes, say, a $1/share dividend, it has $1/share less capital in its coffers. Either a piece of its profits has been paid out to you, or the company has dipped into its reserves or taken on debt if it’s stretching to pay out a dividend during unprofitable times. Either way …
Since your stock represents an ownership stake in the company’s worth, a dividend payout devalues the worth of your shares in equal measure.
In short, receiving a company’s $1 dividend has the same effect as selling $1 worth of its stock. One hopes a thriving company will soon make fresh profits to replenish its share value and fund future dividends. But as with any other stocks you may hold, there’s no guarantee.
Dividend Streams Can Dry Up
There’s another reason dividend stocks tend to appeal to investors. Especially in retirement, you may prefer to differentiate your available spending cash from your continued investment dollars. In behavioral finance, this is called mental accounting. Even though money is money, we like to mentally compartmentalize it, assigning different roles to different “pots.”
Creating an income stream out of a stock dividend pot scratches this mental accounting itch. But there are hitches to this itch. Even if a company has been distributing dependable dividends for years, that does not mean it always will. If a company falls on hard times, its investors may not only lose the dividend they’ve been counting on, the company’s attempts to prop up unsustainable dividend payments may weaken its broader ability to recover.
A well-known example occurred just a few years ago. Prior to 2018, General Electric had long been a faithful favorite among dividend stock investors. So much so, that the company continued struggling to pay out decent dividends, even when it could ill afford to. Its efforts grew increasingly unsustainable, until GE finally surrendered in fall 2018, slashing its quarterly dividends from 12 cents to 1 cent per share, where it remained for several years.
As James Mackintosh of The Wall Street Journal observed at the time: “Dividends should be the result of a successful business throwing off cash, not something that executives strive to maintain even when the cash could better be used elsewhere.”
Worse, the strategy may disappoint you at the worst time. The Wall Street Journal columnist Jason Zweig described what happened to many dividend stocks during the Great Recession:
“In 2007, 29% of the S&P 500’s dividend income came from banks and other financial stocks … [and] That didn’t end well. Many banks that had been paying steady income to shareholders suspended their dividends – or even went bust. Their investors suffered.”
This brings us to our next point about turning to dividend stocks as a separate income source.
Dividend stocks may offer a more obvious way to generate cash flow compared to their non-dividend counterparts. But at the end of the day, they are still stocks, subject to the same risk factors and expected equity premium common to all stocks. As this Monevator post describes, “The key to (most) bonds is they aim to pay you a fixed income until a certain date, at which point you get your initial money back. That is very different to equities [stocks], which offer no such certainty of income or capital returns.”
In short, the evidence is clear: Dividend stocks are stocks. And in the near term, stocks are a more volatile investment than bonds. This helps explain their higher expected long-term returns.
Key Points So Far
OK so we now know that:
- Dividends are not “free.” They are more like a return of your capital than an extra return.
- Dividend stocks may not provide the dependable income stream you’re hoping for across markets that are forever volatile in the short term. A company being pressured to pay out dividends may also engage in practices that run counter to its sustainable worth.
- Dividend stocks are still stocks, with risk characteristics that best position them for generating long-term expected returns, rather than for milking as near-term cash cows.
Admittedly, there are more dubious ventures than concentrating on dividend stocks. Take, for example, piling your life’s savings into speculative schemes such as cryptocurrency, SPACs, or Jim Cramer’s latest “Mad Money” picks. (Here’s John Oliver’s clip on that, for a laugh.)
Why Might You Want to Invest in Dividend Stocks
One of the main reasons why investors like these investments is because they consider the dividend a bonus. They think they are getting interest, in addition to the growth. Many times (but not all) this turns out to be correct.
Another plus of dividend stocks: They provide a hedge against inflation. Some of the well-established companies payout dividends that help combat the decreasing purchasing power of money.
Broadly speaking, dividend payers are often considered defensive. These tend to be more mature companies, with strong cash flow and the ability to earn enough to initiate (and maintain) a dividend. These companies primarily come from industries such as healthcare, staples, energy, and utilities. Big-name tech and internet companies usually are not considered dividend payers.
One last advantage of dividend-payers is the potential for tax advantages. If a company pays “qualified dividends”, that typically means they are taxed at lower rates than ordinary income. So the tax rates on qualified dividends are either 0%, 15%, or 20%, which is usually much lower than the individual’s tax rates of 22% to 37%).
But Are Dividend Stocks a Good Investment Today
One might conclude that defensive stocks would be less volatile in a market downturn. In theory, more solid and well Most recently in 2022, the overall markets were down substantially. Dividend stocks more or less broke even, so relatively speaking, outperformed by quite a bit.
How have they held up in prior recessionary periods? Going back to 1980, a recent Morningstar study show that 3 of the 6 periods showed dividend stocks outperformed the broader markets. That means that they underperformed in the other 3. So, a mixed bag.
But this chart goes back a little further:
If you look further at the types of dividend companies, some prioritize paying high yields. They might sacrifice other growth initiatives to maintain that high dividend (and are known as “high-dividend stocks”). They would rather pay out their profits than invest them. These stocks have attractive yields but also come with some risk.
Contrast that with “dividend-growth” stocks. These stocks don’t usually boast the burly yields that high-dividend stocks do, but they tend to raise their dividends over time. These companies may have exhibited 25+ years of consistently raising dividends. Not that they will always be able to do that, but some love to see that track record.
Others take a middle-of-the-road strategy, balancing company growth while trying to pay/increase their dividend. These are typically known as growth and income stocks. Growth and income have performed slightly better than simply high dividend stocks in recessions, presumably due to being “higher quality”.
In the end, bear markets are an unavoidable part of long-term investing. They have happened before and they will happen again.
Dividend stocks have generally proved resilient during most of these bear markets and recessionary periods. They would make a solid addition to almost any balanced portfolio. With that said, the focus should be more on constructing a quality portfolio, not simply focusing on the highest-yielding one. Fundamentals and valuations play a big part.
If you’d like to know more, please be in touch.