Dividend stock investing is a great source of passive income. The problem is, with dividend yields relatively low at 2-3% you need a lot of capital to generate any sort of meaningful income. Even if you have a $500,000 dividend stock portfolio yielding 3% that’s only $15,000 a year. Remember, the safest withdrawal rate in retirement does not touch principal. Furthermore you must ask yourself whether such yields are worth the investment risk.
If you’re relatively young, say under 40 years old, investing the majority of your equity exposure in dividend yielding stocks is a suboptimal investment strategy in my humble opinion. You’ll be hoping for filet mignon for decades while you eat Hamburger Helper in the meantime. When you reach your desired age for retirement, you might just be asking yourself, “Where the hell is the feast?”
Out of the few multi-bagger return stocks I’ve had over the past 16 years, none of them have been dividend stocks. I’m sure dividend stocks will provide over 100% returns if you give them a long enough amount of time. But if you are like me, you’d rather build your fortune sooner rather than later. If I’m going to bother taking risk in the stock markets, I’m not playing for crumbs. When things turn south, everything turns south so there had better be more than a 3% dividend yield and some underperforming appreciation to compensate.
The following article will attempt to argue why younger investors should focus on growth stocks over dividend stocks in a bull market with potentially rising interest rates. In a bear market, everything gets crushed but dividend stocks should theoretically outperform.
A FUNDAMENTAL POINT TO UNDERSTAND ABOUT DIVIDEND PAYING COMPANIES
The main reason companies pay dividends is because management cannot find better growth opportunities within its own company to invest its retained earnings. Hence, management returns excess earnings to shareholders in the form of dividends or share buybacks. If a company pays a dividend equivalent to a 3% yield, management is essentially telling investors they can’t find better investments within the company that will return greater than 3%. Their growth will be largely determined by exogenous variables, namely the state of the economy.
Pretend you are the CEO of a hot growth company like Tesla Motors (TSLA), the maker of high performance electric cars. Do you think Elon Musk, the actual CEO is going to start paying a dividend with its profits instead of plowing money back into research & development for new models with longer battery lives? Of course not! It would be absolutely pathetic if Elon Musk could not beat a 3% return on its capital. Tesla Motors is up 500% since going public in mid 2010 and now Elon is a billionaire.
Lets look at a telecom company like AT&T (T) which has the largest wireless network in America. Mobile phone penetration is over 85% in America according to Pew Research, and AT&T has the largest subscriber base in the industry. The opportunity for accelerated growth is low, but the cash flow generation is high since AT&T is like a utility. As a result of strong cash flow and no better investment alternatives, AT&T pays a fat dividend of $1.80/share, equivalent to a 5% dividend yield with the stock at $35. Since the 2009 bottom, AT&T has risen 50%, UNDERPERFORMING the S&P 500’s 140% rise.
Just look at the comparison between Tesla Motor’s share price in blue and AT&T’s share price in green and there is no comparison. A $10,000 investment in Tesla in 2010 is now worth close to $50,000. A $10,000 investment in AT&T is 2010 is now worth $10,300, a terrible 3% return. But wait you say! If we add on the average dividend payment of 4% for the two years, we’ve got about a 11% total return in AT&T vs. a 500% return for Tesla.
Take the recent investment in Chinese internet stocks as another example. It would take three years of 3% dividend collecting to achieve the 10% return in one month assuming the stocks don’t grow. For VCSY, it would take 1,666 years to match the unicorn! Now of course the dividend stocks should also grow in a growing market, but so should growth stocks so we can effectively cancel the two out.
EVERY COMPANY HAS A LIFE CYCLE SO BEWARE
One of the greatest growth stocks in history was Microsoft (MSFT). But as you can see from the chart below, Microsoft hasn’t moved much since 2003. If you were a young lad who decided to buy dividend stocks in the 1980s instead of Microsoft while you had a chance, you’d be kicking yourself 20 years later. Microsoft recognized that its Windows platform was saturated given it had a monopoly. Meanwhile, PC growth was stalling out so only then did they start paying a dividend in January 2003.
As a dividend stock, Microsoft is not bad with a ~2.8% dividend yield. They clearly have tons of cash on the balance sheet and a very sticky recurring business model. The problem is that with a company so big, it’s hard to grow faster than the market anymore. The same problem plagues Apple.
What’s scary is that many companies have very short life cycles. How many companies did we know 10 years ago which are no longer around today due to competition, failure to innovate, and massive disruptions in its business? Tower Records, WorldCom, Circuit City, American Home Mortgage, Enron, Lehman Brothers, ATA Airlines, The Sharper Image, Washington Mutual, Ziff Davis, Hostess Brands and Hollywood Video are all gone! This is why you cannot blatantly buy and hold forever. You’ve got to stay on top of your investments at least once a quarter.
DIVIDEND INVESTORS SHOULD WORRY ABOUT RISING INTEREST RATES
Over the last several months US Treasury bonds have collapsed with the 10-year yield skyrocketing to 2.25%. We are now at 12 month highs and a 50% bounce from the bottom. If you believe interest rates are slowly going to rise as the Federal Reserve starts tapering off its quantitative easing, dividend yielding stocks and REITs will significantly underperform the broader stock market. Dividend stocks and REITs act much like bonds in this scenario.
I personally don’t think the 10-year yield is going to 3% within the next 12 months, but just the sceptre of rising rates will cause dividend yielding stocks and REITs to underperform. If the 10-year yield actually goes to 3% from ~2.2% currently, bond investors are going to start losing money. You do not buy REITs and dividend yielding stocks in a rising interest rate environment.
To give you a better understanding of how rising interest rates negatively affect the principal portion of a dividend yielding asset just think about real estate. If 30-year mortgage interest rates suddenly climb from 4% to 6%, there is going to be a serious slowdown in demand for new homes because of affordability reasons. As a result, home appreciation will slow or even decline to get back to supply/demand equilibrium. The same thing will happen to your dividend stocks, but in a much swifter fashion like you see below with Realty Income’s 20% correction over one week. Realty Income is down 2% today vs. 0.95% for the S&P 500.
Of course there are always tactical opportunities in oversold situations. If interest rates ease off a bit, all these REITs that are getting blow to bits will have a nice bounce.
YOU’VE GOT TO BUILD THE NUT FIRST
It is very difficult to build a sizable nut by just investing in dividend stocks. (Read: Build Your Financial Nut So Contributions Matter Less Over Time) The words “dividend growth stock” is almost an oxymoron because the larger your dividend grows the more it means management cannot find better use of its cash. Some people mistakenly take “dividend growth stocks” to mean these are growth stocks with growing dividends. There might be some companies with such qualities, but that is a conflicting statement as we’ve learned above.
Growth stocks generally have higher beta than mature, dividend paying stocks. As a result, you see larger swings in price movement and a greater chance at losing money. But for someone in their 20s, 30s, and even 40s it’s better to go a little farther out on the risk curve for more return because you’ve got more time to make up for any losses.
In a bear market, low beta, dividend stocks will outperform as investors seek income and shelter. Clearly we are not in a bear market yet, but who knows for sure. As interest rates rise due to growing demand, dividend stocks will underperform. They may even get slaughtered depending on what you invest in. You’ve got to decide how defensive and offensive you want to be.
If I think there is an impending pullback, I sell equities completely. I’m not a fund manager looking to outperform a down market by losing less with dividend stocks. I’m an absolute return manager looking to not lose any money, period and so should you. We retail investors have the freedom to invest in whatever we choose. Many funds have limits of 3-5% maximum cash holdings so they are forced to rotate into defensive names.
FINAL POINT: YOU SHOULD ALREADY BE DIVERSIFYING OR DIVERSIFIED
If you read my recommended net worth allocation by age and work experience post, you’ll see that my base case scenario in the second half of our lives is to have roughly a 30%, 30%, 30%, 10% split between stocks, bonds, real estate, and risk free investments like CDs. If you follow such a net worth split, then you already have a healthy amount of assets that are paying you income.
If you decide not to diversify your net worth and go all into dividend stocks, it’s possible to replicate such income, but it will be hard. You’ll also be in for some sleepless nights when the markets turn. The gross rental yield on my main rental property is 8%. Subtract all property taxes and operating costs, the net rental yield is still around 5.5%. Only names like AT&T can come close to matching such a dividend yield, and it’s doubtful AT&T will grow as fast as my San Francisco rental property with a surge of new companies and jobs in the Bay Area.
A lot of young folks are so excited about the initial stage of a portfolio’s growth because each contribution is a good percentage of the portfolio. If you’ve only got a $50,000 portfolio and you add $2,000 a month for a year, you’ll likely have around $70,000-$80,000. A 40%-55% growth in your portfolio is great until you realize it’s your savings contributions that provided most of the growth. Eventually you will hit a wall.
Heavily overweighting dividend stocks is a fine choice for those who have the capital and seek income within the context of a stock portfolio. Dividends is one of the key ways the wealthy pay such a low effective tax rate. But before you deploy a large dividend stock strategy, you’ve got to make your money elsewhere first!
1) It’s very difficult to build a sizable financial nut with dividend stocks because management is returning cash to shareholders instead of finding better opportunities within the firm to invest.
2) Dividend stocks tend to underperform in a rising interest rate environment. Think what happens to property prices if rates go too high. Demand falls and property prices fall at the margin.
3) If you properly diversify your net worth you will already have a good portion of your net worth producing a steady stream of income through real estate, CDs, and other income producing assets. Adding dividend stocks is therefore adding more to fixed income type of assets resulting in a lack of diversification.
4) Match your investment style with your stage in life. It is backwards to aggressively invest in dividend stocks when you are young when you’ve got little capital. A $100,000 dividend portfolio will only yield around $3,000 in income a year.
5) Dividend stocks are fantastic for older investors who want to generate lower taxed income with potentially lower risk. If you think we are heading into a bear market, losing less with dividend stocks is a good strategy if you want to stay allocated in equities. Rebalancing out of equities may be an even better strategy.
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Updated on 12/1/2014. Let the bull market continue. Don’t forget to rebalance your portfolio and manage your exposure and risk.