Dividends are a double-edged sword for investors

By: Jimmy Dot Direct

div_swordThe dividend story has been a part of investing for generations. It is just as valid today as in the past.  In fact, it has taken on even more importance in today’s low-interest rate environment. With the ten-year treasury bond yielding only 1.5% investors are looking for alternatives to both dividends and growth. This has created a renewed interest in dividend stocks. An example would be AT&T (T) which currently yields 4.75%, paid quarterly. For many, the attraction to the  higher dividends is a need for more current income than they can find in safer investments. Therein lies the challenge of risk versus reward. While AT&T may offer a higher yield it also comes with a higher degree of volatility and risk. This is where the investor has to do the necessary due diligence before putting money at risk.

The following is a simple process to follow in determining if a dividend stock fits into your portfolio:

  1. Know your risk tolerance. At what point would you be willing to sell if the stock were to decline in value. Returning to our example of AT&T, the volatility range was approximately 15%. That means the stock value could move down 15% for any period. If your risk tolerance is 8% (meaning if the stock value drops 8% you want to exit the position.) buying AT&T would be a problem. You would only frustrate yourself by selling,  only to see the stock move back up in value. It is important to understand the volatility range of the stock over the trailing 3-5 years to determine if you can stomach owning the stock… regardless of the dividend rate of distribution. Measuring these simple analytics helps investors decide before they buy.
  2. Know what sectors offer you the best opportunity relative to the current environment and looking forward. You want to find undervalued sectors that have created a value relative to the future outlook for the sector, as well as the stock. ETFs offer a way to do this with diversification and lessen the volatility range discussed above. For example, National Retail Properties (NNN) is a REIT that invests in real estate focused on leasing to retail stores. In 2015 the value created by a 20+% dip in value created an opportunity to own the REIT at $36 with a $1.80 dividend or roughly a 5% dividend. Over the last year,  the price has risen back to $50 or a 38% gain on the price, plus the dividend of 5% for a total return of 43%. This is a great example of how value and dividends work together. The goal is to buy the position at a discount and hold until which time the value climbs back to normal valuations. The example of NNN happened in a twelve month period. In the case of AT&T above it took 42 months to realize the upside gain of 27% and collect a 5.6% dividend along the way. The key is finding the right value in the right sector, whether you buy the stock or the entire sector in a REIT or ETF.
  3. Understand the valuation of the position relative to the current environment. Utilities (XLU) can be bought in an ETF to own all the stocks versus picking one. In 2013 the value was below average based on the current economic and sector outlook. The ETF yielded just over 4% at the time. By fourth quarter 2014 the ETF rose 38% in value and the dividend declined to 3.3% current yield. The valuation picture for the position was high as was the risk of ownership. By asking yourself one simple question, “Would I buy it now?” , you can get a feel for the risk of the position currently. Most investors will evaluate based on where they bought and where the position is currently. Asking yourself if you would buy it now gives you a better understanding of the current valuation. If the answer is no, tighten your stops to protect the downside and let it play out. Know where you are, where you are going, and the risk associated with the distance relative to the reward.
  4. Evaluate the dividend history of the asset. Have they ever cut the dividend? If so, why? If not, have they raised it regularly? Know what the potential gains are relative to the potential risk. Dig in, dig deep and understand the risk of what you are buying.

The goal of investing is to make money. The challenge is that an investor can stomach the volatility in order to make money. For that reason alone you much do your homework, regardless of the investment type, before buying. Too often investors will buy the sizzle and forget to evaluate the steak. Know what you are buying, know why you are buying it and determine if you can ride out the volatility periods in order to collect the dividends and growth of the asset.

In today’s low-interest rate environment, it is easy to be attracted to higher yielding assets, but it is equally important to be attracted to and understand the risk that comes with the dividend or yield associated with the asset. Do your homework and perform your due diligence before you buy.

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