Three Overlooked Costs With Dividends

Editors’ Note: MarketMinder Europe doesn’t make individual security recommendations. Any mention herein is incidental to the broader point we wish to illustrate.

Perhaps it is slower newsflow over the summer months, with many institutions traditionally on break. Perhaps people are seeking a lighter, more reflective beach read. Perhaps it is because most news in financial headlines today doesn’t seem very new. But whatever the driver, dividends—cash payments distributed by a publicly traded company to its shareholders—have grabbed attention in financial publications we follow as of late. Here are three reasons why investors benefit from not overrating dividends, as they carry costs many don’t realise.

An Opportunity Cost for Investors

Focussing on dividend-paying stocks can mean zeroing in on a handful of equity sectors, which are typically value-orientated and/or defensive in nature (think Financials, Consumer Staples and Utilities, according to our research).^[i] There is nothing wrong with these sectors, but a dividend-focussed portfolio will have a couple major blind spots from a diversification perspective, in our view.

For illustrative purposes, take America’s S&P 500 Dividend Aristocrats Index, which tracks S&P 500 companies that have increased dividends every year for the past 25 consecutive years.^[ii] Its top three sectors by market capitalisation (market cap) are Consumer Staples (23.6%), Industrials (21.8%) and Financials (13.3%) whilst its smallest is Information Technology (2.7%).^[iii] Tech also happens to be the strongest-performing sector over the past 10 years.^[iv] Since August 2016, the S&P 500 Dividend Aristocrats returned 169%.^[v] Over that same span, the S&P 500 Total Return Index is up 317%—powered by Technology’s 886% surge.^[vi]

Now, the past 10 years don’t predict the next 10, and our studies have shown that every style, industry and sector has its time in the sun (and rain). But over the past decade, we think an investor targeting dividend stocks would have paid a huge opportunity cost—potentially missing growth in other parts of the market.

An Opportunity Cost for Businesses

Companies typically loathe cutting dividends since investors often interpret reductions as signs of trouble. But paying dividends may force companies to delay spending or investments.

For example, in 2014, grocer Tesco slashed its dividend as part of a business strategy reset.^[vii] Similarly, US telecom AT&T nearly halved its dividend in 2022 to allocate cash to capital expenditures (e.g., expanding its 5G wireless footprint).^[viii]

A company deploying cash to pay a dividend means that cash isn’t funding innovation. That can be fine! We have nothing against dividends! But a firm that can’t spend on growth-orientated initiatives may fall behind competitors, as the lack of investment can erode competitive edges. We aren’t advocating firms plough all their cash into growth regardless of cost. But for investors, it is worth considering how companies are managing their finances and positioning themselves for the foreseeable future.

A High Dividend Yield May Be Illusory

Some dividend chasers see high yields as attractive—ignoring the fact the dividend isn’t a return on capital, but rather a return of capital (by definition, the amount of a dividend is subtracted from the share price). Moreover, a higher yield may actually reflect the company’s stock tanking. In his 2013 book The Little Book of Market Myths, Fisher Investments founder and Executive Chairman Ken Fisher discussed how US utility company PG&E’s dividend yield rose in the early 2000s even as its stock price fell.^[ix] (PG&E eventually suspended its dividend.) BP had the same experience in 2020, after COVID lockdowns ravaged oil prices and hammered the company’s revenues.^[x] Because a dividend yield reflects past payments and current stock price, a plunging stock price can result in a higher yield.

More recently, this appears to be the case for US mortgage lender United Wholesale Mortgage (UWM), whose high annual dividend yield (around 33%) was largely due to its tanking share price.^[xi] That price was a signal of trouble—and UWM suspended its dividend last week.^[xii] So the yield you think you bought may be illusory. The trouble hitting the company you bought because of a lofty yield may be much more real … and costly.

As always, we aren’t inherently for or against dividend-paying stocks. But for investors, remember there is nothing special about these payments, and there are other ways to generate cash flow to meet your needs.