So you have decided to invest in dividend paying stocks. Welcome to the club! 🙂 This form of investing can be very profitable on a long term. As I described in my post on “How to be a millionaire?“, the main principle is to continuously invest your savings and let time and compounding work for you. The idea is simple, nevertheless there are quite a few traps on the way. In this article I will explain the reason behind the biggest dividend investing mistake you can make.
The main idea behind dividend investing is quite simple: you buy shares in a company, it pays you dividends, from the dividends you buy additional shares and the value of your investment grows. You are basically rolling a dividend snowball that gets bigger and bigger.
How much dividend you receive depends on two things: the amount of shares you own and the amount of dividend the company pays by share. The annual gross amount of dividend per share divided by the share price is called the dividend yield.
If a company pays 50¢ on a quarterly basis, that’s 2$ per year, and if the share price is 100$, that means the dividend yield is 2%. Simple, right?
You start doing your research on possible stocks to invest in. You will realize that some of them are yielding around 1%, some 3%, 8% and some don’t pay any dividends at all. As here we are talking about dividend investing mistakes, let’s focus on the dividend paying stocks.
If the amount of reinvested dividends will make such big difference on long term future returns, it is a no-brainer to go for the highest dividend yielding stocks, right? Mathematically yes, but here is where you might make your biggest dividend investing mistake!
The Dangers of Yield Chasing
Remember that dividend yield is the annual dividends per share divided by the price per share. Please note that both variables are changing. The share price can change in every second and the amount of dividend is also depending on the decision of the board of directors. If a company pays 50¢ this quarter, it is not a guarantee that the dividend will be the same next time as well.
You also need to understand that by investing in dividend stocks you are taking on some risk. Right now the 10 year bond yield in the US is around 2.4% (the German yield is 0.3%). This is basically a risk free return for your money. People buy stocks because they are hoping for higher returns. These returns can come from the increase of the share price, dividends received, or a mix of these two.
The Impact of Interest Rates
The share price is determined by tons of different factors. Here we are only focusing the dividends. Let’s take a fictive company with a share price of 100$ and an annual dividend payment of 3.4$. The dividend yield is 3.4%, which means people are expecting 1% extra vs the risk free rate, in return of taking an extra risk.
What happens if the 10 year US bond yield increases by 0.5% to 2.9%? In our over simplified example, people will expect a 3.9% return on their investment in this company. Taking that the annual dividend payment remains unchanged at 3.4$, this would mean a share price of 87.18$.
As the amount of dividend remained unchanged, this might not worry the long term dividend investor. However, should you be in a position that you need to sell your shares, this price drop might be painful.
Does it work the other way around too? Absolutely! This is one of the reasons why dividend stocks were performing so well during the low interest rate environment.
The Impact of Company Earnings
Bear in mind that dividends have to be paid from somewhere. In an ideal situation the source of the dividends is the earnings of the company. Now let’s take the same fictive company as above and say the earning per share (EPS) of the company last year was 6.8$. Considering the 3.4$ annual dividends, this is a quite safe, 50% dividend payout ratio. Even if the earnings dropped by 1$, the dividend would be covered by the earnings.
But if the earnings were 3.8$, a 1$ EPS drop would force the company to cut its dividends. In addition a dividend cut might trigger some share sell-off, so investors would be hit both in terms of dividends and share price.
Why Should You Be Careful with High Yields?
High yield itself is not the problem. However, it can be an indication of a potential problem. Bear in mind that stocks are pricing the future. What do investors do when they believe that the company has problems? They sell, which results in a drop of the share price. And in case of an unchanged dividend payment a drop in the share price means higher yield.
Very high yields are always temporary. The market always finds the optimal balance. It can happen two ways.
Let’s go back to our original example. The company has 3.4$ annual dividend per share and the share price is 100$. Let’s assume that a 3.4% yield realistically performs the risk premium that investors are willing to take.
The business environment of our company is bad. Investors are worried about a dividend cut. The share price plunges 30% to 70$. Right now the dividend yield is 4.86%. There are two main options:
1) There is indeed a dividend cut. Investors holding the shares for the expected 3.4$ dividend per share have burned themselves. A dividend cut is also a bad message towards the investors and many would sell their shares, generating further decline in the share price.
2) The company manages to get out from the difficult situation without a dividend cut. In this case the share price will raise again as everyone would consider the 4.86% yield a great deal.
Two Real Life Examples
If you look at my portfolio, you will see that I own some shares of Banco Santander. This is an early purchase of mine from a bit over 2 years ago. That time I made probably the biggest dividend investing mistake: I chased the yield. When I made that purchase, Banco Santander was yielding around 8%.
All I saw was the high yield and did not even mind to check whether it was sustainable or not. Of course it wasn’t and less than half year later the company cut the dividend. I didn’t sell and this still stays as a memento in my portfolio, reminding me to my mistake. But who knows, it might turn out to be a profitable purchase on a long term.
One thing is for sure: I’m grateful to learned this mistake in an early stage and not when dividends will be a major source of my overall income. In that case a dividend cut would really hurt.
Another example I want to share with you is Royal Dutch Shell. My average purchase price is less than EUR 22 (currently trading around EUR 26). When I started to buy, the dividend yield was around 8%. Why? Because of the big decline of the oil prices has seriously hit companies in the industry and many of them were forced to cut dividends. Investors were worried that Shell will follow.
So far the dividend of Shell remained uncut and if we can believe the management it will stay like this. The share price has rallied nearly 40% during 2016 and if the oil price stabilizes above 50$, I believe the dividend yield will further drop. This might mean a share price well over EUR 30.
Because of this reason, and as I want to fill my tank from Shell dividends, I will keep adding to my position in the next couple of months. The future will tell whether my theory is right, or this will be another Banco Santander failure.
Buying stocks just because of the high yields is probably the biggest dividend investing mistake. Don’t chase the yield! Too high dividend yields can mean problems around the company, therefore you should always be very careful there. Dividend cut could be on the way. It doesn’t mean though that these are 100% wrong trades. If you do your research carefully, you might be able to identify some undervalued stocks that could be great contributors to your dividend portfolio.
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Disclaimer: This post or any other information on the site is not intended to be and does not constitute financial advice or any other advice. I am solely sharing my idea, plan and progress on early retirement.