Valuation indicators (3/9)

Dividend yield

The first question that comes to mind when you start looking into dividend investing is: how much distribution can I get from my purchase? As a result, most people rush to THE most used criterion of this strategy: the famous dividend yield, or Yield in English, which measures the ratio between dividends paid per share over a year and the share price. I have always warned my readers about the risk of focusing solely on this ratio, and the more it goes on, the more I am convinced not only of its lack of usefulness, but especially of its risks.

Just like the P/E ratio, the dividend yield is not only a widely followed and easily accessible indicator, but it also works better with larger companies. This makes sense given that the dividend is a share of the profit. The former, however, has one undeniable advantage over the latter: it is impossible to manipulate. In fact, it is the only factor that a company cannot falsify because it goes directly into your wallet.

The first problem with dividend yield is that this strategy is followed by a very large mass of institutional and private investors. The approach was particularly popularized with the famous Dogs of the Dow, the Dow Jones stocks that pay the best dividends. Of course, this strategy is interesting because it offers a mechanical and contrarian approach, while focusing on solid companies, at least in principle... Indeed, even large capitalizations of the Dow Jones can be in real difficulties. Kodak and GM were part of the famous Dogs, before going bankrupt! And since the high yield strategy is very fashionable, it tends to saw off the branch on which it is sitting. Income and performance suffer.

When we focus on dividend yield, we also expose ourselves to tax consequences. A high income is certainly useful and even necessary when we are looking for financial independence, but by trying to inflate it too much, we also start to fatten the state coffers too much, to the detriment of our own. In Switzerland in particular, stock market capital gains are not taxed, unlike dividends. I am not saying that we should focus on securities that do not pay distributions, but rather choose those that offer a moderate income. In fact, these are the ones that offer the possibility of making the best gains.

Finally, and most importantly, the strategy based solely on high dividend yields poses one last major risk, that of the reduction of distributions, or even their complete elimination. Indeed, by focusing on companies that pay juicy income, we also focus most of the time on companies in difficulty. Dividends are high for a good reason: the price has recently fallen because the organization is experiencing difficulties, temporary or not. There is no guarantee that the dividend paid in the past will be maintained, because if the company has financial problems, there is a good chance that the distributions will be reduced, or even completely eliminated. In this case, by investing in this stock, you lose both the income you were looking for and the capital you invested (because prices have a very unfortunate tendency to undergo corrections according to the dividend policy). It is a bit like if you were the owner of an apartment, your tenant no longer pays you rent and your property had lost half of its value... not very interesting. In June 2008, Bank of America (NYSE: BAC) was yielding over 10%. Anyone who bought BAC for its generous yield ended up with a stock that not only paid almost no dividend 9 months later, but also had a completely unscrewed price during the same period...