Should You Reconsider Dividends?

Summary: Dividend stocks have been riding a renewed wave of popularity. Investors appreciate dividends due to the reliable income streams they produce, along with their potential for capital appreciation. Click through for an overview on dividends to see whether they’re right for you.

Dividend stocks provide a relatively low-risk strategy and a hedge in volatile markets. This is because they frequently pay out during turbulent times. For example, over the course of the COVID-19 pandemic, as pharmaceutical firms enjoyed a boost in revenues, some were ready to increase their dividends or pay out a one-off dividend bonus.

However, dividend portfolios do come with warnings attached. Companies can cut or eliminate their dividends, taking a bite out of their portfolio yield in the process.

Across a pack of 1,400 dividend-paying firms, 213 pared dividends and 93 omitted dividends in the second quarter of 2020 as COVID-19 reared its head. Another less-appreciated risk is the danger of concentration in dividend-focused portfolios, both by sector and within industries.

Birds of a feather

High-yield companies tend to fit a similar mold — the way by which they are overrepresented in mature industries, featured amongst large firms as well as value stocks and affected by businesses with interest-rate sensitivities.

• Mature industries: These have peaked in terms of revenue and earnings in the corporate life cycle, such as food, agriculture, natural resources and financial services.
• Large firms: Nearly 84% of companies in the S&P 500 index pay dividends, compared to 70.5% in the S&P midcap index and a mere 54% in the small-cap index.
• Value stocks: These are considered undervalued bargains, trading at a lower price relative to sales and earnings than their high-flying growth counterparts.
• Interest rate sensitivity: Interest rates affect the prices of dividend stocks in sectors such as utilities, telecom and real estate investment trusts. Basically, there are both competition and pressure from bonds and other sources of yield.

Around which sectors does a cluster of dividend payers gravitate? Well, in a typical fund or portfolio, you might find financials and real estate playing major roles, followed by energy, utilities and basic materials. Next come consumer goods, health care and telecom. For investors seeking diversification, the challenge is to manage lumpy portfolios that are overstuffed with banks and oil drillers.

The lessons of sector diversification transpired in 2020 as firms and sectors differed in their responses to economic slowdowns and new regulations. Some sectors proved vulnerable to slashed dividends, such as consumer discretionary, energy, financials and industrial. Others were better positioned to maintain or even expand their payouts, including health care, consumer staples and IT.

Global diversification

Dividend yields also vary on a geographical dimension. Many non-U.S. companies have more generous payouts, although they may be less committed to sustaining a steady increase in yields than are their American counterparts. Keep in mind, though, that you will be receiving their dividends in another currency, which will also fluctuate against the U.S. dollar, thereby impacting the final amount of money you will ultimately pocket.

Some of the largest, most stable and most reliable foreign companies have been raising their dividends for at least the past five years. Some stellar names to which this applies include Novo Nordisk in Denmark, Novartis in Switzerland, Westpac Banking in Australia and ACE, the Swiss insurer.

At the end of the day, you must know what you own. It is advisable to check each of your exchange-traded funds or mutual funds for their specific holdings. Do they overlap, creating another layer of concentration risk?

Furthermore, dividend-rich investments provide a solid platform for building a blue-chip stable for generating income. Make sure you discuss any strategies you’re considering with your financial adviser to confirm that your ideas are suitable for the needs and goals of your individual profile.

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