Dividend investing is a popular strategy — not just for retirees who need the consistent income payouts, but for prudent investors who desire to pad the volatility of uncertain markets. With markets reaching all-time highs by the day, it may be wise to batten down the hatches with some high-quality dividend stocks, which will make it easier for those of us with lower risk tolerances to stomach the next correction, which could present its ugly face at any time.
If the markets were to head into bear-market territory all of a sudden, you’d likely see a chunk of your profits go up in smoke. But with a high-dividend stock, you’ll collect the payouts, and those are yours to keep and use as you like, regardless of which direction the market is headed.
“Over the last 40 years, 71% of the stock market’s return came from dividends, not capital appreciation,” said Kevin O’Leary, Shark Tank star and well-known Canadian dividend investor who refuses to invest in any stocks that don’t pay a dividend.
The mistake that many new dividend investors may be making
Many dividend investors are guilty of being “yield hungry” and are forgetting to consider the valuation and long-term growth prospects of a business. Such investors will favour a particular stock just because it has a higher dividend yield at a certain point in time. While a high yield may be a top priority for many, dividend investors have been flocking into high-yield names and may be overpaying for such stocks.
Consider BCE Inc. (TSX:BCE)(NYSE:BCE), a market darling with a bountiful 4.72% dividend yield, the largest yield of the Big Three Canadian telecoms. It’s a solid, blue-chip stock which has enjoyed a great deal of capital appreciation and dividend raises over the years. To many dividend investors, it’s a core holding, regardless of the valuation or potential headwinds that may mount in the future.
Sure, you’ll get the yield you wanted, but your total return would likely suffer, since you paid such a hefty premium to begin with. Many retirees often state that they don’t care for capital gains; they’re in it for the long term, and they just want a high dividend yield to support their lifestyles. That’s not a good mindset, because not only will your capital gains be lacklustre, but your dividend could grow at a slower rate than that of its higher-value peers over the course of many years.
A rising interest rate environment is bad news for many income investors
As rates continue to rise, many high-dividend-paying sectors like REITs, utilities, and telecoms are going to experience a gradual reduction in profitability. In the case of BCE, it’ll need to ramp up on capex to maintain its network and fight off new competitors. With interest rates rising, that will be less cash back in the pockets of shareholders over time. And with shares of BCE still trading at a premium, I think a lot of dividend investors who’ve overpaid for the stock are going to be let down over the next five years, mostly because of sub-par capital gains, which will dampen total returns.
Dividend investing isn’t all about the yield.
Yes, it’s nice to have a higher yield, but if you overpay for it, your total return will be poor. There’s no way around it. You’ll always need to consider the value you’ll get before you buy a stock, or you could cost yourself a great deal over the long run.
Don’t chase yield. Instead, consider a stock’s valuation, growth prospects, catalysts, dividend growth, then look at the current yield. This way you’ll pay a lot less for a high-yield stock and you’ll likely be happy with your total return for many years.
Stay smart. Stay hungry. Stay Foolish.
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Fool contributor Joey Frenette has no position in any stocks mentioned.