Brad Kinkelaar of income giant PIMCO recently shared some great dividend insights (and great charts) with Josh Brown of The Reformed Broker. There’s the typical schtick in there about the importance of dividends as a percentage of returns even in a bull market, and the importance of thinking beyond domestic utilities to other industries and even international players … but there was one great chart that I think every dividend investor needs to see.
This is the breakdown of how stocks performed based on the size of their dividend yield. It’s broken down into “deciles,” or 10 different chunks. The 10% of stocks with the most miserly dividend yields are listed on the far left, and the 10% with mammoth, double-digit yields are on the far right.
Note that the biggest returns aren’t in the stocks with the highest yield. There’s actually a sweet spot for dividends in the sixth and eighth deciles.
In short, some stocks with a modest yield of 3.5% or so might actually deliver outsized returns, topping companies with double the yield.
Why is this? Well, because yield is too often the dividend trap investors don’t see coming. The sad reality is that it’s much easier for a company to double its yield by watching its share price get slashed in half than to increase its actual payments 100%.
It’s a simple math equation to calculate yield, dividing the annual payout by the share price. And if you can’t increase the payout … you simply decrease the price, and that pushes up the yield.
That’s what happened at Hewlett-Packard (NYSE:HPQ), which now yields 3.6%. Shares were over $70 in late 2007 and the dividend was an annualized 32 cents a year — a measly yield of 0.5%. The dividend has been increased to 52 cents annually … but with shares under $15, the yield is stupendous these days.
There’s also the sustainability question when a company is suffering like this. After all, if a stock is slumping dramatically, you have to wonder whether they can afford to keep up the payouts that have resulted in the outsized yield.
Take Arch Coal (NYSE:ACI), which had a double-digit yield earlier this year … but slashed its payout from 11 cents a quarter to 3 cents. Same with homebuilder KB Home (NYSE:KBH), which slashed its dividend from 25 cents annually to 10, or retailer JCPenney (NYSE:JCP), which suspended its dividend altogether.
So much for those big dividends.
This kind of fuzzy math persists on Wall Street, and investors need to be wary of looking at metrics in a vacuum. For instance, when companies buy back a ton of shares, they might artificially boost their earnings as a result. After all, it’s earnings per share that Wall Street watches — and if you can’t increase the earnings to make that EPS figure higher, sometimes the simplest way to make the math work in your favor is to dramatically reduce the shares.
So beware of placing too much credence in headline stock statistics — particularly yield. As the research from PIMCO shows, there are many times when a stock with a modest yield actually is better for your portfolio in the long run than a volatile payer with a double-digit dividend.
- 5 tech stocks with +3% yield. (The Slant)
- Can you predict dividend cuts if you know where to look? (The Motley Fool)
- Check out this great list breaking out the S&P’s biggest dividend stocks by sector. (Bloomberg)
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.