Is Dividend Investing Broken?

Dividend-seekers like me tend not to swing for the fences. I don't need to double my money in the next 12 months. If I can collect nice yields between 3% and 7% from my stocks, I'd be satisfied with annual total returns in the 9%-13% range. And with modest expectations, the risks should be modest, too.

Yet this has been a miserable bear market for dividend investors, and high-profile tragedies like  Citigroup (C) and  Wachovia  are just the beginning. Dozens of companies, large and small, have slashed or eliminated their dividends in the past year, depriving investors of billions of dollars in annual income. The Morningstar Dividend Leaders Index, which tracks the returns of 100 high-yield stocks, has lost nearly a third of its value since its May 2007 peak (even with dividends included)--more than double the loss borne by the S&P 500. And as far as I can tell, no meaningful segment of the high-yield equity universe has been immune from falling prices.

This begs a good question: Is dividend investing broken?

I don't think so. I find a strategy that seeks above-average income from stocks just as appealing as ever--and if anything, the potential returns from here look better than they did a year ago. Perhaps, as editor of the Morningstar DividendInvestor newsletter, these are the kinds of things you'd expect me to say. But I have to agree that this bear market has thrown much of the conventional wisdom about dividends out the window.

Defenestrating Conventional Wisdom
I've run across lots of myths about dividends over the past few years, and I enjoy debunking them when I have the opportunity. But for now, let's focus on just two: the idea that high-yield stocks are less risky than stocks with low yields or none at all, and the related notion that a large dividend will keep a stock from falling.

Unfortunately, these two bits of "wisdom" have flunked the reality test.

• Volatility in market prices does not necessarily translate into risk for committed, long-term shareholders, but volatility can tell us something about the risks perceived by the marketplace. In this respect, high-yielding stocks have actually become more volatile than the market as a whole. In 2005 and 2006, daily returns for the Morningstar Dividend Leaders Index were 17% less volatile than those of the S&P 500. But during 2007 and thus far in 2008, high-yield stocks have been 23% more volatile than the S&P 500.
  
  
• Stocks naturally compete with bonds and CDs for investors' capital, so it's tempting to believe that a dividend yield of 4% or 5% in this environment would bring on lots of buyers--enough to offset the selling of other investors (perhaps those hot-money types with short time horizons). But there's a big difference between the dividend on a stock and the interest payment on a Treasury bond or FDIC-insured CD: Dividends are not guaranteed--not by the company, the government, or anyone else. So if the dividend is at risk of being cut--or just perceived as being at risk--there's no floor under the stock price.
  
  To cite one example, let's consider one of my favorite banks,  BB&T Corporation (BBT). Its dividend has risen in each of the last 37 years, including a 2.2% hike in June, and this bank (unlike too many of its peers) structured itself to maintain shareholders' paychecks even when times got tough. Back in the spring, BB&T was trading around $35, giving the stock a yield in the 5% area. But when panic set in across the banking industry, even the durability of BB&T's payout couldn't prevent the stock from falling as low as $19 in July (at which point it yielded almost 10%).

Dividends: Still the Real Deal
As I see it, the key to navigating market conditions such as these (or, for that matter, any market conditions) is for the investor to have a very clear sense of purpose.

While dividends offer many real, tangible benefits to the investor, I find their greatest appeal in the prospect of large, predictable cash returns that don't depend on market prices. I've never found dividends attractive because they would make my portfolio less volatile, or keep a stock's price from falling. But because dividends take time to collect, they virtually force the investor to take a long-term view. Over a good stretch of years, the day-to-day volatility of prices stands to cancel out.

This is why I can afford to accept periods of high price volatility for my portfolio, and I can even hold when prices are plunging. I don't dwell on the prices too much; instead, I focus on the income my stocks put in my pocket. So long as I buy good stocks for the right reason, I can go on cashing my dividend checks regardless of what happens to the stock price in the meantime.

Of course, I don't want to simplify matters too much. Owning BB&T in this bear market has been rewarding only because its dividend continues to grow, and I've increased my advantage by buying more shares at lower prices. The same example doesn't apply to a  National City  or a  Fifth Third (FITB), whose dividends have been cut (and their stock prices clobbered). Market prices don't need to matter unless you have cause to sell--but then prices become very important indeed.

That's why DividendInvestor takes both a broad and a narrow view. Narrow: I take the time to consider a company's dividend prospects thoroughly before buying, focusing on both dividend safety and dividend growth potential. As a result I can count 128 separate dividend increases and only one dividend cut for my portfolio holdings since January 2005. Broad: I like my holdings a lot, but they're only means to an end. The strategic decision--to own stocks with reliable and rising dividends--takes top billing in all markets. Only then I can let prices fluctuate, as they surely will, without losing heart.

		DividendInvestor Newsletter
	DividendInvestor is a monthly newsletter that focuses on showing you how to profit from the compound		effect of dividends and growth. This one-year subscription consists of 12 monthly issues. Learn More.
	$185.00 for 12 Print Issues		$175.00 for 12 PDF Issues