Investors Beware: Dividend Stocks Becoming a Crowded Trade

by Ross Heart on July 17, 2012

investing risks, investment risks, stock market risks, taking risk, risky bet, risk signBy Ross Heart
If you are currently investing in dividend stocks, have invested in them, or are considering them, you may also be aware that there exists a bit of an “it’s a no brainer to buy dividend stocks” consensus right now in the marketplace. Furthermore, it is very difficult to find someone who is not recommending large-cap dividend payers.

It’s hard to blame them, though, as dividends have historically provided a very large percentage of stock market returns… and let’s face it, receiving cold hard cash in the form of a dividend is probably the most investor-friendly way a company can distribute its earnings.

But investors also know, and sometimes forget, that dividend stocks are also about timing (and avoiding the herd), sustainable earnings, and stock price valuation. With this in mind, the current dividend investing mentality and appeal elicits four time periods that are burned into my memory:

  • 1995-98 when buying the S&P 500 index fund was a no-brainer because baby boomers had to stick their 401k investments in the market
  • Technology and Internet Stocks shortly thereafter
  • Clients calling in 2005-2007 deriding common stock investments and wondering why they shouldn’t flip Florida condos
  • Large investment pools and endowments making certain they were allocated to commodity stocks and investments just prior to 2008

Reactions I’ve recently come across by dividend stock proponents include: “no, this is completely different than those periods”, or “no, I don’t mind getting paid to wait” or “where else am I going to put my money?” These are not investment rationales in my opinion; they are big fat red flashing signs that make we worry when, not if. These responses may not be a repeat of previous “herding” escapades, but they sure do seem to rhyme.

In my humble opinion, dividend investing has the potential to be much more problematic than the above four time periods. I see the potential for frustration (and upset investors), as many recent converts to dividend stocks may not be emotionally prepared for account losses. Furthermore, that this dividend stock obsession is derived from an ultra-low interest rate policy forcing savers to scramble and replace needed income lost from cd’s, bonds, money markets, and other cash producing investments only compounds the problem if the proverbial fan gets hit.

The average holding period for an investor holding stocks has declined dramatically over the years, as investors have become far less patient (a much needed mindset in buying dividend stocks – think Warren Buffett and his ‘forever’ time frame). As well, long-term investors resolve is sorely lacking for an investment discipline that demands it. Frankly, the above four time-periods were really momentum driven as investors continued to buy and chase investments at higher prices because they simply (and seemingly) refused to go down. This is a whole other animal.

Great American companies like Nike (NKE), McDonald’s (MCD), and Caterpillar (CAT) are stocks that may be chirping like canaries in the coal mine. All pay dividends, but if you look closer, recent declines in their share prices have equated to multiple quarters of dividend payments. Common stocks are not bond-substitutes regardless how low interest rates go. Do we really need to be told stocks hold substantial risk after all we’ve been through this past decade? We haven’t even touched on the possibility that corporate earnings start to shrink – if they do, a double-whammy of declining share prices as well as reduced payouts could body-slam investors who’ve been forced out on the risk curve by the current zero-interest rate policy.

I am not suggesting that you eliminate dividend stocks from your arsenal, but am cautioning investors to reconsider making investments blindly based on yield. Time periods where investments have become substitutes for savings vehicles have a dubious history. Evaluate companies (and all investments) based on a wide swatch of criteria versus succumbing to popular wisdom that you should simply own dividend stocks. Just as the late 1990’s proved selecting stocks purely based on a P/E ratio was fallacy, this time period may end up testing the simplicity of making investments purely based on yield.

At the time of this writing Ross Heart and Heart Capital LLC did not own any shares in any company mentioned in this post.

Heart Capital does not offer investment advice via this medium. Under no circumstance whatsoever do these postings, opinions, charts, or any other information represent a recommendation or personalized investment, tax, or financial planning advice.

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Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of his employer or any other person or entity.

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