Written by: Derek Majkowski. Any opinions are those of Derek Majkowski and not necessarily those of RJFS or Raymond James.
Total return is measured by both capital appreciation and dividend payments over time. If a stock does not pay a dividend, then obviously return is only measured by growth. Over time, dividend contributions to total return have varied in importance, but it has long been generally acknowledged that dividends are nice things to receive, and add to the overall return on an investment.
Traditional beliefs would also suggest that dividend paying companies are generally less volatile than those companies that do not pay dividends, because you can count on a steady quarterly or semi-annual cash-flow. The tradeoff being that an owner of dividend paying stocks may sacrifice some in potential capital appreciation when compared to non-dividend paying companies.
That has long been a general and traditional way of thinking. Through most of the first two-plus quarters of 2016 however, the opposite has been true. The defensive, higher dividend paying companies on the S&P 500 have performed very well through the summer of this year. The markets were generally led by names that typically pay higher dividends such as utilities and telecom companies. So much so, that the capital appreciation since the beginning of the year, in some cases, reached double-digit performance. They moved a lot like your non-dividend paying names that primarily rely on growth.
Due to the big run up in appreciation, I would call clients that may own a number of these higher dividend paying companies and suggest we potentially pair back, or prune some of the position based on the very attractive move in appreciation since the beginning of the year. While some obliged, others resisted due to the attractive dividend and yield.
I would often hear, “but it pays a good dividend and has a good yield, why would I want to sell?” It’s a completely reasonable question, and when making any decision to sell one needs to take into consideration short and long-term goals, and obvious tax considerations.
Clearly, no one has a crystal ball when providing recommendations to buy or sell, but when resisting the decision to sell simply due to a dividend yield may also be a bit misunderstood. This is especially relevant when an investment purchased primarily for dividend and yield, accelerates in price in such a way that you can capture years of that income in advance.
To illustrate, let’s consider a telecom company that we’ll call company XYZ. In January of this year, let us assume the company’s stock traded around $35 a share, and pays a dividend of approximately $0.50 per share quarterly ($2.00 annually). At $35 per share that is over a 5.7% annualized dividend yield.
In July this year XYZ Company’s stock has appreciated to $43 per share. That represents over a 22% move up in 7 months, or at $2 per share annually, the equivalent of 4 years’ worth of dividends in 7 months. The dividend yield is now 4.65% annualized at a $43 per share price. That is still pretty attractive, but why pass up the ability to capture that dividend advance due to a quick move?
Now consider that the stock price for XYZ drops to $39 per share in October. The price is still higher than where it was in January, but since July the $4.00 per share price drop is like taking away your next two years in dividends if the price remains relatively flat.
Again the yield and overall return is attractive at the current price level, but the near term drop eliminated the equivalent of 2 years of that dividend if the price remains relatively static. Yes the company’s stock price can go back up in time, but it can also go lower.
When a company’s stock makes a relatively quick and unusual move up without some news event, especially a company that is generally purchased and owned for a steadier price and dividend; it may be reasonable to consider the trade-off of selling and taking the capital gain and capturing, theoretically, that dividend income in advance.
Of course one has to weigh the tax situation and goals when deciding to sell, but the dividend yield should not be the only factor of consideration when managing an individual position. Years of dividends can be gained and lost relatively quickly in markets, and one need to factor in both outcomes when deciding what to do with their dividend paying stocks.
The examples provided are hypothetical and have been included for illustrative purposes only. These examples do not represent any actual investment. Dividends are subject to change and are not guaranteed, dividends must be authorized by a company's board or directors. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Any tax matters should be discussed with a tax professional.