Four Overlooked Costs With Dividends

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

Perhaps it is “silly season” of slower newsflow. Perhaps people are seeking a lighter, more reflective beach read. Perhaps it is because most “news” there is doesn’t seem very new. But whatever the driver, dividends have dotted headlines of late. We highlighted a couple dividend-focused articles in last week’s “Headlines” section, and our May dividend “reminder primer” provides our fundamental views on the subject. But given the topic’s recent popularity, here are four more reasons investors shouldn’t overrate dividends, as they may cost you in ways you don’t realize.

An Opportunity Cost for Investors

Focusing on dividend-paying stocks can mean zeroing in on a handful of equity sectors, which are typically value-oriented and/or “defensive” in nature (think Financials, Consumer Staples and Utilities). There is nothing wrong with these sectors, but a dividend-focused portfolio will have a couple major blind spots from a diversification perspective.

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

Now, the past 10 years don’t predict the next 10, and every style, industry and sector has its time in the sun (and rain). But over the past decade, 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 2013, telecom CenturyLink cut its dividend by -25% to help pay off debt as analysts fretted over the company’s home phone and internet business prospects.^[iv] Similarly, telecom AT&T nearly halved its dividend in 2022 to allocate cash to capital expenditures (e.g., expanding its 5G wireless footprint).^[v]

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-oriented 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.

Don’t Forget the Taxman

Dividends, which are taxed in the year they are paid, fall into two buckets: qualified or nonqualified (i.e., ordinary).^[vi] The former is taxed at the long-term capital gains rate (0%, 15% or 20% depending on an investor’s filing status and total taxable income).^[vii] The latter is taxed at one’s federal income tax rate, which can range from 10% to 37%. High-income taxpayers may also owe the 3.8% “Net Investment Income” tax, which would make the highest federal rate on qualified dividends 23.8%^[viii]

So, depending on the dividend status and holding period, dividends may actually be taxed at a higher rate than capital gains. That means it could be more tax efficient to sell stocks for cash flow needs than rely on companies kicking in dividends.

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 absolutely tanking. In his 2013 book The Little Book of Market Myths, Fisher Investments founder and Executive Chairman Ken Fisher discussed how the 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.) 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 United Wholesale Mortgage (UWM), whose high annual dividend yield (around 33%) was largely due to its tanking share price.^[x] That price was a signal of trouble—and UWM suspended its dividend last week. 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.