Many years from now, the story of General Electric (GE, Financial) will be taught in business schools as how not to run a business. The group's exceptionally complicated structure and highly leveraged balance sheet looked sustainable when everything was going to plan, but as the business has stumbled, it has all quickly unraveled.
Many investors had come to trust a General Electric as one of the most reliable dividend payers in the Dow Jones Industrial Average. For this reason, the stock featured heavily and many retirement portfolios. It was a blow to dividend investors all over the world when the company finally revealed that its dividend payout was no longer sustainable.
General Electric is, in my view, a poster child of all that is wrong with dividend stocks. It has been clear for some time that the company hasn't been able to afford its dividend and pursue other strategies, such as debt reduction and Investment in the business. But management seems to prioritized the dividend above all else, and investors lapped up the income story.
This brings me to my main argument: the dividend fallacy.
The dividend fallacy
Over the past 10 years, there has been a general rush for yield in the markets as investors have sought out the market's best income stocks, with little regard to any other financial metrics apart from dividend yield. This is not a sound investment strategy.
Unfortunately, companies have only exacerbated the situation by prioritizing dividend payouts above all else, borrowing money to sustain distributions as earnings have stagnated.
As interest rates rise it is going to become harder and harder for these companies to keep their promises to investors. I think there are going to be many more General Electrics before the end of this cycle.
If you are looking for dividend stocks, the data shows that chasing yield is probably the worst thing you can do.
This is not new data. In fact, it comes from a research paper entitled "High Yield, Low Payout" that Credit Suisse Quantitative Equity Research published way back in August 2006.
The researchers looked at the returns of dividend stocks between January 1980 and July 2006. They created equal weight decile baskets based on dividend yield as of each month-end and then followed the returns.
Interestingly, over this period, the stocks with the highest yields (decile 10) actually underperformed the deciles 9 and 8, although even the underperforming decile 10 achieved a return five times higher than the lowest dividend stocks.
The researchers also went deeper into what makes a good dividend stock. They found within the higher dividend universe there was a direct correlation between low payout ratios and higher returns. This might seem counterintuitive. Stocks with higher dividend yields should produce higher returns. But the data shows that is not the case.
According to the report, which analyzed dozens of data points between 1990 and 2006, the high-yield, low-payout portfolio bucket generated an annualized return for the period of 19.2% versus 11.16% for the S&P 500. In comparison, the high-yield, high-payout portfolio bucket generated an annualized return of 11%. The low dividend yield high payout ratio bucket produced an annualized return for investors of just 8.6% from January 1990 to June 2006.
These numbers clearly show that if you are looking for high-quality dividend stocks to include in your portfolio, you should be seeking out those firms with high yields, but low payout ratios. The report stopped short of trying to explain why this is the case, but if I was to hazard a guess, I would say that companies paying out less to investors have more money to be invested in growing the business, paying down debt and thinking about the future. With more money going into securing the long-term outlook, earnings may expand faster, driving capital growth to complement dividend income.
Disclosure: The author owns no share mentioned.
