Why Dividend Stocks Aren't a Screaming Deal

Many investors have flocked to dividend stocks to boost their investment income. With yields on bonds, bank CDs, and other fixed-income investments near historical lows, dividend stocks look quite attractive by comparison.

In fact, the dividend yields on many blue-chip stocks now greatly exceed the rates they pay on their corporate bonds. But what may surprise you is that although bond yields have generally been higher than stock dividend yields for decades, the reverse was true throughout much of the 20th century -- and there's reason to believe it might hold true again for a while.

The dynamics of dividends
When Fool contributor Russ Krull looked at the dividend-yield phenomenon this week, he noted that low bond rates make it cheap for companies to get debt financing. Companies can also use cheap financing to improve their cash flows by turning around and using newly issued debt to buy back their shares. The money they save on dividends more than makes up for the interest they pay on the bonds.

That makes investing in those stocks sound like a no-brainer. But to come to that conclusion, you have to assume not only that the total returns on those stocks will be higher than what the corresponding bonds return, but also that investors will receive an appropriate risk premium for their trouble.

In other words, because stocks are more volatile than bonds and are more susceptible to bankruptcy and business failure risk, investors should demand higher returns on stocks than on bonds. And when those returns can't come from capital gains, they should show up in higher dividend yields.

Moving from dividends to capital gains
Historically -- prior to the 1970s -- dividend stocks routinely paid higher yields than high-quality bonds. Although those yield differentials often narrowed or went away entirely during bull markets, they reasserted themselves when stocks declined.

Yet throughout the big bull market of the 1980s and 1990s, stocks routinely had far lower yields than the rates on the bonds they issued. At first, that was a direct consequence of extremely high interest rates stemming from the inflationary conditions of the late 1970s. But even as interest rates subsided, dividend yields failed to catch up with them.

That in part came from a move away from dividends and toward share buybacks. During much of that period, income tax rates on dividends were the same as rates on other income, leading to full double-taxation at both the corporate and individual level. Share buybacks, on other hand, avoided that result, leading to favorable tax treatment.

But the side effect of that anti-dividend policy was to shunt more of a stock's returns into capital gains. While dividends put money in your pocket directly, share buybacks have a more indirect wealth effect, pushing share prices higher and creating capital gains.

Saying goodbye to gains
Over the past decade, by contrast, share-price gains have been hard to come by. As a result, an increasing portion of total return has come from dividend yield.

Today's high dividend yields likely point toward relatively low expectations for capital gains in the future. Looking at some of the companies with the biggest yield differentials between bonds and stocks, you can see some justifications for those expectations:

  • AT&T (NYS: T) and Verizon (NYS: VZ) are at the forefront of the mobile revolution, which could prove extremely profitable. But the telecom giants have had to make immense investments in wireless infrastructure -- risky moves that could potentially become obsolete long before the companies recoup their hefty capital costs.

  • Merck (NYS: MRK) and Pfizer (NYS: PFE) both face big patent cliffs that are forcing them to reinvent the way they do business. With major changes including Pfizer's divestiture of its infant-nutrition business, Big Pharma is preparing for a new paradigm -- one that is far from a sure thing.

Company-specific issues also play a role. For instance, Johnson & Johnson (NYS: JNJ) has plenty of promising attributes, but it has also suffered through years of adverse events, including numerous product recalls and lawsuits that have damaged its reputation. If it doesn't recover, the shares could be dead money for the foreseeable future.

The point isn't that these stocks are automatically bad investments. But their high dividend yields suggest that much of their total return potential is already baked into their payouts, so expecting big capital gains on top of the dividends could be overly optimistic.

No slam dunk from dividends
When you see dividend yields rise above bond rates, you shouldn't automatically assume that the shares are a screaming buy. Only after looking closely at each company to examine its growth prospects can you accurately assess whether you're getting a reasonable premium for the risk you take on.

The right dividend stocks really can make a big difference to your portfolio. Learn how to maximize your investment income in The Motley Fool's free report, "Secure Your Future With 9 Rock-Solid Dividend Stocks." Click here for instant access today.

At the time thisarticle was published Fool contributor Dan Caplinger likes dividends but tries to be realistic. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Johnson & Johnson. Motley Fool newsletter services have recommended buying shares of Pfizer and Johnson & Johnson, as well as creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is always a great deal.

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