Dividend Stocks: Port in a Storm?

October 14, 2022
Dividend-paying stocks could potentially pump up total returns from your stock portfolio and generate extra income.

With stocks in a bear market, inflation running hot, and recession risks rising, you might be wondering if any part of your stock portfolio is likely to generate returns in the coming months—or if preserving your capital is the best one can hope for in this environment.

There are no guarantees in investing, of course, but investors looking for potential ports in the storm for their stock allocations could consider focusing more on steady dividend payers.

"Dividend payers tend to be big, well-established companies that have an abundance of cash," says Steve Greiner, vice president of Schwab Equity Ratings®. "In this market, it can make sense to focus on measures of quality—those with good cash flow, low debt-to-equity rations, good earnings, and a record of profitability—particularly if they're in more defensive sectors."

Here's what to know about dividend stocks, and how to pick appropriate ones for you.

The perks (and pitfalls) of dividend payers

Dividends, when reinvested, can significantly boost total returns over time, making dividend-paying stocks an attractive option for older and younger investors alike.

For example, if you invested $1,000 in a hypothetical investment that tracked the S&P 500® Index on January 1, 1990, but didn't reinvest the dividends, your investment would have been worth $11,687 as of September 2022. If you had reinvested the dividends, you would have ended up with just over $20,000—nearly double.

More bang for your buck

Reinvesting dividends could significantly boost total returns over time.

Chart compares S&P 500 price returns with S&P 500 total returns.

Source: Charles Schwab

Monthly data from 01/01/1990 through 9/01/2022. Calculations assume a starting portfolio value of $1,000. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. Past performance is no guarantee of future results. 

"Of course, dividend-paying stocks are generally much riskier than bonds, something income investors in particular should consider when weighing their options," Steve says. "Especially now that you can find decent yields on Treasury bonds."

What's more, dividends aren't guaranteed, unlike the interest payments from Treasuries. Companies can trim or slash their dividends at any time, a risk that was realized in 2020 after 68 of the roughly 380 dividend-paying companies in the S&P 500 suspended or reduced their payouts.

"Fortunately, companies generally only cut dividends when they're in distress," Steve says, "so favoring those with sound financial metrics can help mitigate this risk."

How to pick dividend stocks

These six tips can help you identify dividend-paying stocks with strong financial health:

1. Don't chase high dividend yields

"There's a reason—and not always a good one—that a security is offering payouts that are well above its peers or the broader market," Steve says. "Before jumping at a big yield, try to determine why it's so high."

Dividend yield is calculated by dividing a stock's total annual dividend payouts by its current share price. If a high or rising yield is due to a shrinking share price, that's a bad sign and could indicate that a dividend cut is on the horizon.

If a rising dividend yield is due to rising profits, on the other hand, that's a much more auspicious sign. "When net profits rise, dividends tend to follow suit, so just be sure you know what's causing the increase before buying the stock," he says.

2. Assess the payout ratio

This metric—which is calculated by dividing dividends per share by earnings per share—tells you how much of a company's earnings are going toward the dividend. "A ratio higher than 100% means the company is paying out more to its shareholders than it's earning," Steve says. "In such cases, it may be able to cover its dividends from available cash, but that can last only so long."

If a company whose stock you own is losing money but still paying a dividend, it may be time to sell. "Dividend payers in financial straits may try to stave off a dividend cut—which can drive away shareholders—by funding payouts with borrowed funds or dwindling cash reserves," Steve says. "It's rare that such measures turn things around, though. They're usually just delaying the inevitable."

3. Check the balance sheet

High levels of debt represent a competing use of cash. "If push comes to shove," Steve says, "the company is going to pay its creditors before it pays its dividends."

A good rule of thumb is to favor companies with a "current ratio"—a measure of the company's current assets versus its current liabilities—of 2 or higher, which is a good indicator of its ability to cover its short-term obligations.

4. Look at dividend growth

Generally speaking, you want to find companies that not only pay steady dividends but also increase them at regular intervals—say, once per year over the past three, five, or even 10 years. Indeed, companies that grow their dividends tend to outperform their peers over time.

Supersize me

Over the past 40 years, stocks that maintained or grew their dividends outperformed those that cut their payouts or offered none at all.

Bar chart shows stocks that grew or initiated dividends offered total returns of 14.19% between 1981-2021. Returns from stocks that didn’t change dividends were 10.88%, those from stocks that cut or eliminated dividends were 10.9%, and those from stocks that didn’t pay dividends were 10.04%.

Source: Compustat, Ned Davis Research, S&P Capital IQ, and S&P Dow Jones Indices.

©2022 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved. See additional explanatory notes and disclosures at ndr.com/copyright.html. For data vendor disclaimers, refer to ndr.com/vendorinfo. Past performance is no guarantee of future results.

5. Understand sector risk

Some sectors offer a more attractive combination of dividends and growth than others—but they also offer different risk characteristics that you should consider when researching dividend payers for your portfolio. Stocks from the banking, consumer staples, and utilities sectors, for example, are known for steady dividends and lower volatility, but they also tend to offer less growth potential. Dividend-paying tech companies, on the other hand, could offer attractive dividends along with the opportunity for larger price gains, but they also tend to be much more volatile.

"If you're a long-term investor, you might be willing to accept tech's higher volatility in exchange for its growth and income prospects," Steve says. "But if you're nearing or in retirement, you might want to stick with dividend payers from less-volatile industries."

6. Consider a fund

If you're worried about the potential for price declines eroding the value of your dividend stocks, consider instead a dividend-focused exchange-traded fund (ETF) or mutual fund. Such funds typically hold stocks that have a history of distributing dividends to their shareholders, and they can provide a greater level of diversification than you can achieve by buying a handful of dividend-paying stocks.

Do your homework

No matter what stage of life you're in, dividend-paying stocks can be a great way to supplement your income and improve your portfolio's growth potential. Just be sure you research the companies' overall financial health, not just their dividend rates, before investing.

When not to reinvest

Three situations in which you might want to deploy dividend payouts elsewhere.

  • You're in or near retirement: When you're living off your savings, taking income from your dividends allows you to let more of your portfolio stay invested for growth. If you're nearing retirement, on the other hand, you can use the payouts to build up your cash and short-term reserves as you prepare for the transition to life after work.
  • Your portfolio is out of balance: Reinvesting the dividends of a well-performing investment back into that investment can throw your portfolio off balance over time. In such cases, you might want to take the cash and reinvest it elsewhere.
  • The investment is underperforming: If you're worried about an investment's future prospects but aren't quite ready to let it go, you may not want to reinvest the payouts back into that investment. Instead, you might use the dividends to dip your toe into prospective investments that could ultimately replace the underperforming investment.

Three situations in which you might want to deploy dividend payouts elsewhere.

  • You're in or near retirement: When you're living off your savings, taking income from your dividends allows you to let more of your portfolio stay invested for growth. If you're nearing retirement, on the other hand, you can use the payouts to build up your cash and short-term reserves as you prepare for the transition to life after work.
  • Your portfolio is out of balance: Reinvesting the dividends of a well-performing investment back into that investment can throw your portfolio off balance over time. In such cases, you might want to take the cash and reinvest it elsewhere.
  • The investment is underperforming: If you're worried about an investment's future prospects but aren't quite ready to let it go, you may not want to reinvest the payouts back into that investment. Instead, you might use the dividends to dip your toe into prospective investments that could ultimately replace the underperforming investment.

Research can pay dividends

How to research dividend payers on schwab.com.

Log in to schwab.com/stockscreener to research dividend stocks by:

  • Payout ratio: Select Dividends under the Choose Criteria menu, then select Payout Ratio - TTM and choose a range.
  • Current ratio: Select Financial Strength under the Choose Criteria menu, then select Current Ratio and choose a value.
  • Sector: Select Basic under the Choose Criteria menu, then select Sectors and Industries and choose a sector.

To review a stock's dividend growth, log in to schwab.com/research-tools, search for the company name or ticker symbol, and select the Distributions tab on the stock's research page.

To research dividend-paying stock funds, log in to schwab.com/ETFscreener (for ETFs) or schwab.com/fundscreener (for mutual funds), select Distributions under the Choose Criteria menu, then select Distribution Yield and choose a range.

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Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges, and expenses. Please read it carefully before investing.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Dividend-focused funds may underperform funds that do not limit their investment to dividend-paying stocks. Stocks held by the fund may reduce or stop paying dividends, affecting the fund’s ability to generate income.

Investing involves risk, including loss of principal.

Performance may be affected by risks associated with non-diversification, including investments in specific countries or sectors. Each individual investor should consider these risks carefully before investing in a particular sector or strategy.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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