Getting to Know Dividend Stocks

In a world of persistently low interest rates and economic uncertainty, many investors have turned to dividend-paying stocks for income and stability. Many of those investors may have been dismayed earlier this year when the prospect of higher interest rates sent some dividend-paying stocks tumbling.

Historically, dividend-paying stocks have not been subject to the kind of interest rate risks that come with other income-focused investments.

Nevertheless, as the Federal Reserve contemplates its first interest rate increase since 2006, investors need to be more selective. Not all dividend-paying stocks are the same—a number of factors affect a company’s value and dividend payout. For example, utility and telecommunications companies, whose stocks are popular for their relatively high dividend yields, tend to be relatively slow growing and debt laden. These characteristics could put pressure on a company’s ability to increase dividends in rising interest rate environments.

Let’s take a closer look at dividend-paying stocks, how they have fared in rising rate environments and how to assess them.

Seeking income

Many investors like dividend-paying stocks because they can offer a relatively regular source of cash flows—most dividends are paid quarterly. Companies in the S&P 500^® Index paid a record $45 billion in dividends in February, according to S&P Dow Jones Indices, and full-year payments are poised for a fifth straight annual gain of at least 10%.¹

This resonates with income-focused investors such as retirees, who often rely on recurring sources of income to help pay their bills.

Those looking for growth as well as income might consider the benefits of reinvestment. Reinvesting your dividends—adding your earnings to your original investment—can help boost returns through the power of compounding. This can create a snowball effect, as the original investments, plus the income earned from those investments, can grow together over time. Or it can cushion losses during down periods.

For example, if you had invested $68.56 in the S&P 500 on December 31, 1974 (the closing value of the index on that date) and reinvested all of your subsequent dividend payments, your portfolio’s value would have grown to $6,140.23 by the end of 2014, according to research by ThomasPartners,^® Inc. Take dividends out of that equation and the simple price appreciation would have netted you $2,058.90 over the same period.²

Dividend stocks and interest rates

As the market awaits the Fed’s interest rate hike, many investors are wondering how dividend-paying stocks will fare in a rising rate environment. As you can see in the chart below, research by ThomasPartners found that dividend payers, particularly those that increased or initiated a dividend, delivered returns that were consistently higher than those from both non-dividend payers and those that cut their dividend in the 36 months following an initial rate hike.

Assessing dividend-paying stocks

Dividend-paying stocks are not without risk. So what should you pay attention to when you’re considering them?

First of all, it’s worth emphasizing that dividend-paying stocks don’t provide the downside protection afforded by many bonds if held to maturity.

Another major source of concern is the ability of a company to continue paying dividends at the current rate—or at all. Dividends are paid at the discretion of the board of directors, which can raise, lower or eliminate a dividend whenever it chooses.

In assessing dividend-paying stocks, you should ask yourself a few questions:

What is the stock’s dividend yield? Steve Greiner, who leads the Schwab Equity Ratings^® team within the Schwab Center for Financial Research, says his team takes special care to analyze each company’s ability to continue supporting its dividend and raise it over time.

One red flag is when a stock’s dividend yield—or the ratio of how much a company pays out in dividends each year relative to its share price—appears much higher than that of its peers. A rising yield isn’t always good because it can simply reflect a declining share price.

“When I see people chasing dividend yields of 5-6%, I really have to question whether that’s starting to become a distressed security,” Steve says. “In those cases, I have to wonder if the board hasn’t met recently to cut the size of the dividend.”

He says the “sweet spot” for dividend yields is between 3% and 4%, but higher levels could make sense for companies in certain industries, such as oil and gas.

How does the company pay for its dividends? Steve and his team also consider how companies are paying for their dividends. Those that take out additional debt to fund dividends, rather than simply paying them out of earnings, may be at risk of a dividend cut.

“You want your dividend-paying stock to have a strong balance sheet behind it,” Steve says. “Otherwise, you have to worry about the company weathering a tough environment.”

How much free cash flow does the company have? Greg Thomas, Senior Vice President and Chief Investment Strategist at ThomasPartners says, “We look at whether a company is generating sufficient free cash flow to provide headroom for dividend increases.” Free cash flow refers to cash leftover after capital expenditures—or spending on equipment and other infrastructure needed to conduct business. Companies typically use such funds for dividends, stock buybacks or acquisitions.

Dividend-paying stocks can be a potential source of income and returns. However, they come with a different set of risks and aren’t a substitute for bonds in the income-generating part of your portfolio. It’s worth it to be discerning when you invest. Beware of overly high dividend yields and pay attention to a company’s fundamentals. You don’t want your quest for yield to leave you overburdened with risk.

¹“What’s Long Worked for Dividend Stocks No Longer Does as Worries Climb about Interest Rates,” Associated Press, 3/5/2015.

²Growth of this investment in the S&P 500 Total Return Index assumes reinvestment of dividends on December 31 of each year, includes capital gains and does not reflect the effect of taxes and fees. If fees and expenses were considered, returns would have been lower. Hypothetical performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, taxes or expenses and cannot be invested in directly.