Rising inflation has led central banks around the world, including the US Federal Reserve, to hike interest rates several times since early 2022, and the rate hikes have sparked fears of a recession emerging.
Investors may be wondering where they can ride out a recession-induced stock market storm. It seems that during a recession, while many stocks may be a risky gamble, top-performing dividend stocks offer less volatility, higher returns and stable passive income for retirees.
What are dividend stocks?
Dividend stocks reward their shareholders with regular payments out of a company’s earnings. These payouts may come quarterly, semi-annually or annually. The board of directors is responsible for setting the company’s dividend policy and for determining the size of the dividend payout based on the firm’s long-term revenue outlook.
The more shares an investor holds in a particular dividend stock, the higher the payment. If you own 100 shares of a stock paying an annual cash dividend of $3, you will receive $300 in annual dividends from that company.
Cash dividend payments are typically sent to shareholders through the investor’s brokerage account. However, companies may also payout dividends by issuing stock (referred to as a stock dividend), or by offering discounts on stock purchases through dividend reinvestment programs (DRIPs).
Other dividend types include special dividends, which are one time payments to holders of common stock paid out from a company’s accumulated profits; and preferred dividends, which are paid to holders of preferred stock on a quarterly basis at a fixed rate.
When declaring a dividend, an ex-dividend date is set based on stock exchange rules. This date determines whether or not shareholders in the company are eligible for the dividend payout.
Those shareholders that purchased stock before the ex-dividend date are entitled to the dividend. Conversely, if you purchased stock on or after the ex-dividend date, the seller will receive the payout and you will have to wait until the next declared dividend to reap the rewards of holding a dividend stock.
Pros and cons of investing in dividend stocks?
There are several advantages to investing in dividend stocks, especially for those who prefer a long-term approach to investing.
As with any stock, dividend stocks have the potential to increase in value overtime. Stock dividends and DRIPs offer investors the opportunity to grow their holdings. Cash dividend stocks provide a steady flow of income that can be used to pay on a mortgage, vacations, healthcare or a child’s university tuition.
Another attractive feature of dividend stocks is the degree of security they offer. Companies that are able to pay out dividends to shareholders are often well-managed firms with the ability to generate consistent revenues even in the face of a volatile market.
As with most things, dividend stocks are not without their downsides. One such drawback is that you might be saddled with a higher tax burden. While dividend income is not taxed at the same rate as other income sources, especially if they are held in an IRA or a 401(k) plan, if you receive your dividend payments through a brokerage account, that tax rate will be higher than those payments received through a retirement account.
Another downside to dividend stocks is that when companies are doling out a portion of the profits to shareholders, that is less capital being put back into growing the business. This means that dividend stocks have less potential to gain in value. For investors big on growth stocks, these might not be an ideal addition to their portfolio.
There is also the risk that during a downturn in the markets, a company may be forced to pare down its dividend payments or suspend them entirely.
There are a number of important metrics typically available through online financial and brokerage websites that investors can use to evaluate whether or not a particular dividend stock is right for their portfolio. The three most useful metrics are debt-to-equity ratio, dividend yield and dividend payout ratio.
What is debt-to-equity ratio?
The debt-to-equity ratio is used to evaluate a company’s financial health. It calculates the amount of total debt (including financial liabilities) that a company holds compared to its total shareholder’s equity. Basically, it’s a measure of the extent to which a company can cover its debt.
In the context of dividend stocks, a high debt-to-equity ratio can threaten a company’s ability to maintain its dividend. Avoiding companies with a debt-to-equity ratio higher than 2.0 is a good rule of thumb.
What is dividend yield?
While the debt-to-equity ratio can be used to evaluate any stock, the dividend yield is a metric specific to evaluating dividend stocks. The dividend yield is a ratio in percentage form that represents the income paid out to shareholders compared to the stock price.
This ratio changes with fluctuations in the stock price and is calculated by dividing the annual dividend payment per share by the current stock price.
Investors can use dividend yields to compare the investment value of a dividend stock with its peers in a given sector. “Dividend yield can help investors evaluate the potential profit for every dollar they invest, and judge the risks of investing in a particular company,” Business Insider stated.
For example, let’s say company A pays an annual dividend of $3 per share and is currently trading at $50 per share, meaning it has a dividend yield is 6 percent. Company B also pays an annual dividend of $3 per share but its current stock price is $100, which is a 3 percent dividend yield. Company C pays a dividend of $4 per share and its shares are trading at $40, giving it a dividend yield of 10 percent. The average dividend yield for their economic sector is 5 percent. Therefore, Company A is the better choice.
While Company C has a much higher yield, it’s out of line with the sector average and might be a signal that the company poses a greater investment risk. “While a high dividend yield may be appealing, it doesn’t necessarily mean a stock is a smart investment,” Investopedia states. “Overly high dividend yields may indicate that a company is struggling.”
Most financial advisors say investors should look for companies with dividend yields of between 2 percent and 6 percent.
Dividend yields move in the opposite direction of stock price. In our example above, Company C was previously trading at $80 per share before a massive recall of its product was forecast to cost it millions of dollars in lost revenue, causing a massive sell off. Therefore, its ultra high dividend yield is a negative signal to investors.
Conversely, a dividend yield of below 2 percent may be an indication that the company is more focused on growth and investing back into the business rather than sharing profits with stockholders.
The example of Company C is another reason why investors would be wise not to pick stock based on one metric alone. Let’s look at another important tool for evaluating dividend stocks: the dividend payout ratio.
What is dividend payout ratio?
Dividend payout ratio helps investors to measure the risk associated with a particular company’s dividend payment. The ratio is calculated by dividing total dividends by net income. It tells you how much of the company’s net income goes toward paying dividends to its shareholders.
A dividend payout ratio that shows a company is using all of its income to pay dividends does not have a sustainable dividend program. The closer to 100 percent, the more likely a company’s dividend program will be cut once the market cycles into a downturn. Nerd Wallet advises investors to rule out companies with dividend payout ratios of 80 percent or above, while Investopedia reports that companies with dividend payout ratios of less than 50 percent are “considered stable” and have “the potential for sustainable long-term earnings growth.”
What stocks pay the highest dividends?
Investors looking for the most stable, reliable dividend stocks turn to dividend aristocrats. These are S&P 500 stock companies known for consistently increasing their dividends for at least 25 years. Dividend aristocrats come out of a broad range of industries, such as energy, pharmaceuticals, consumer goods, technology, precious metals mining, financial services and automotive.
Some of the best performing dividend aristocrats in recent years include:
Are dividend aristocrat stocks good investments?
It should be noted that even dividend aristocrats are not entirely immune from the havoc a recession can wreak on a company’s financial health.
“Of the 60 dividend aristocrats that existed in 2007, 16 of them cut or suspended their dividends during the financial crisis,” notes Simply Safe Dividends, which offers the Dividend Safety Score system alongside a suite of portfolio-tracking tools. “While bank stocks accounted for the majority of those cuts, it’s never easy to predict which sector will experience the next shock.”
During the economic shock induced by the COVID-19 pandemic in 2020, 25 percent of the companies covered in Simply Safe Dividend’s Dividend Safety Scores cut their dividends that year.
Word to the wise, choosing to invest in a dividend stock generally comes down to your risk tolerance. The best way to mitigate your risk of losing money by investing in a dividend stock is to perform adequate due diligence.
Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article.