The Problem With Buying Stocks for the Dividend

Dividend stocks are a highly searched topic just about anywhere you look, and for good reason. Dividends are a way to achieve "passive income," which is all the buzz on YouTube, LinkedIn, TikTok, etc. But you have to be incredibly selective and lucky to actually strike gold with high-paying dividend companies.

Do you even know what to look for? What do the companies do under the hood?

About the most common high dividend-paying company is a business development company. They lend money to capital-poor private companies and earn interest. They are heavily tied to credit risk, interest rate risk, and business risk.

Not to mention, you are three steps away from what you actually want exposure to: the business loan. You are layered and the last to get paid.

Total Return Matters (Dividends + Capital Appreciation)

AT&T has a high dividend yield, just about 8%, and yes, the dividend return attribution on AT&T is massively high. Most of the returns are coming from the dividends. From the late 80s to today, the price performance on AT&T is only about 86%, while the total return (dividends reinvested) is 1.37K%. When you don't reinvest dividends, that number falls apart really fast, and you are left with an 86% return over 40 years that does you no good.

But on the S&P 500, the price return alone has been 1.06K%, and that means most of the total return performance has come from price performance and dividend reinvestment, which is followed by more price performance.

When you pay for the dividend, you get the dividend only. You also pay a lot more for less certain cash flows.

Pricing a Dividend Company

Dividend companies are priced differently by the market, or at least the companies that prioritize that form of return to shareholders.

There are two different types of dividend stocks: dividend stocks that pay consistent, steady dividends and have near-certain future cash flows, and dividend stocks that don't have one or both of those two things.

Generally, companies in the first bucket have high valuations (price-to-earnings multiples) because they are priced as a regular company that pays dividends. The companies that fall into this camp are generally utility, consumer staples, or energy companies.

But because they have high valuations, they also have low dividend yields. When people are looking for a dividend stock, they aren't looking for low dividend yields, but to get quality dividend companies, you have to look in the lower end of the yield spectrum. And to actually find quality, you have to pay more. It's the way of the world.

The second bucket of dividend stocks has lower valuations (price-to-earnings multiples), but that's mainly because they are unreliable in payments or earnings potential. These companies are generally in the real estate sector (mortgage REITs and other REITs) and business development companies (or companies that invest in the private debt markets).

Yields on these companies can be north of 10% at times, but the price performance can kill your dividend returns.

Even with dividend yields north of 10%, the 5-year total return is next to nothing or negative. Sure, you have some cash flow, but even reinvesting all of those dividends never beats the S&P 500.

But take some quality earnings and dividend payments, and you can see that the dividend yields are lower, but the total returns are higher and beating the S&P 500.

Companies priced on their dividend and dividend outlook are sometimes subject to more price volatility than a company priced on its earnings.

We could continue to go down the list of companies like the AGNC and NLY, but the picture is almost always going to be the same, except for the rare odd pearl as mentioned above. To hit that odd pearl, you almost have to be lucky and in a bull market.

The Question to Ask Yourself

The main point of this post is not to say that cash flow is bad, and the more you have isn't worse. But it is to say that it may not always be the best option.

But ask yourself this: What's better in this scenario?

Scenario A: You get nothing in cash flow, but you know the value will appreciate by 7% every year.

Scenario B: You get a 10% cash flow yield, but the value will remain in decline 5% every year.

The math very quickly checks out to having scenario A at your fingertips.

And remember, with enough assets, you can pledge them for cash at lower rates. This is what the tech CEOs of the world do rather than actually selling shares of their company.