“What can I expect to earn from my portfolio?” “How much do my stocks yield?” These are some of the types of questions we often receive from clients, especially those who are taking regular withdrawals from their accounts. In the last few years, as interest rates have fallen, dividend investing has gained in popularity. While dividends do play an important role in generating returns for shareholders, we like to remind clients that this is just one piece of the puzzle. The total return from a portfolio, which is what investors should focus on, includes interest and dividend income plus price growth. For example, Stock A pays a 5% dividend but had no price growth for a total return of 5%. On the other hand, Stock B pays no dividend but had 10% price growth for a total return of 10%. While the 5% dividend stock might have looked more attractive to the income seeking investor, I think it goes unsaid that we all would have rather owned Stock B. So, where does this price growth come from and how can we maximize total return?
In the short run, stock prices can go anywhere, and often do, sometimes defying logic and frustrating investors. In fact, just the demand for the dividend alone may drive price growth in the short term. But over time, a company that is able to generate earnings and grow those earnings will reward investors with strong price growth. Often times these are companies that pay little to no dividend as they are focused on reinvesting earnings into their core business. High dividend paying companies, on the other hand, are often more mature and may be unable to efficiently reinvest cash flows for future growth.
This is not to say that all companies paying dividends are inferior to those who don’t. There are many successful companies that have paid consistent and growing dividends for decades and have rewarded shareholders nicely. In fact, many of the companies we own pay steady, growing dividends. Rather this is just to caution that it is dangerous to look at just the current dividend yield when evaluating a company. A company that struggles to grow its earnings may be forced to cut the dividend down the line, which could send the stock price tumbling. This scenario is an income seeking investor’s worst nightmare. Several years of dividends could be wiped out in short order due to negative price growth.
Take for example, recently beleaguered ketchup-maker Kraft Heinz. The company has historically paid a dividend in the neighborhood of 5% and in February of this year was trading at roughly $47/share (down from $92 in May 2017). After an earnings report that revealed disappointing results, an SEC investigation, and a 36% cut to its dividend, the stock plummeted and is now trading at roughly $27/share. An investor who bought the stock solely for its 5% dividend has now lost over 40% of their investment due to price decline (or 8+ years worth of dividends), and would have to see a total return of over 70% from current prices just to get back to even.
So, what’s the takeaway? While “income” is hard to come by in this low interest rate environment, you shouldn’t buy stocks just because they pay a hefty dividend. Change the way you think about “income” to include the gains from price appreciation. Your account balance and future self will thank you.