Dividend stocks: quality counts too (Published July 5, 2011)

By MICHELLE TAN

THERE has been a big buzz around dividend stocks since the last global financial meltdown as investors and funds start to see the importance of establishing a regular income source, especially when the going gets tough.

Moreover, with Singapore's population demographics reflecting a fast ageing population, dividend stocks also serve as an avenue to generate income to fund retirement especially for investors with weaker saving habits. However, are dividend stocks really such a god-send, or have they been over-hyped by financial media?

In general, analysts and investors ascribe a lower risk and volatility profile to dividend stocks due to their ability to generate regular streams of income that help bolster the ill-effects of a potential downturn.

But does this mean that dividend stocks are less likely than their lesser yielding peers to see price upswings due to their less volatile nature?

As a simple illustration, should one compare the basket of 30 Straits Times Index (STI) constituents with a basket of 30 dividend stocks, findings show that though both portfolios generated positive year-on-year price returns, the former reflected a higher annual return of 13.8 per cent as opposed to the 9.6 per cent registered by the dividend stock portfolio.

As such, based on the findings, it seems that dividend stocks tend to experience lower capital appreciation when compared to index stocks.

Having said that, the STI basket is made up of blue-chip quality counters that tend to be highly favoured by both institutions and layman investors alike.

Perhaps, if the comparison was drawn to a basket of lower cap counters, findings might have shown otherwise.

Now coming from a dividend perspective, dividend stocks triumphed over the STI basket with the former having a forecast consensus dividend yield average of 6.2 per cent in FY11 and 6.5 per cent in FY12 as compared to the latter's 3 per cent and 3.3 per cent for the respective financial years.

The findings are not surprising though investors should bear in mind that the STI portfolio has some dividend stocks, which would have given a slight lift to the basket's average yield.

Should the basket exclude dividend stocks entirely, the average dividend yield would have been even lower.

More pertinently, the dividend stock portfolio, unlike the STI one, is able to outstrip domestic inflation rates, which is cited as a key worry for investors today.

As such, investors who are unable to buy commodities like physical gold or property to hedge against inflation could perhaps turn to dividend stocks as their answer to a cost-efficient inflationary hedge.

But there are no fool-proof investments in this world. Just like any equity, dividend stocks are still susceptible to industry recessions and other sector-specific woes.

In fact, during the last recession, many dividend stocks such as real estate investment trusts (Reits) were not spared from the falling knife.

Admittedly, there was sunlight after the rain for investors that had the financial muscle to tide through the rough patch.

But for investors who were retrenched and needed the funds, liquidating dividend stocks such as Reits - and other non-dividend stocks - back then would have severely decimated their wealth.

All that said, it is an undeniable fact that all boats sink when the tide falls. But one of the better known ways to break the fall is to diversify.

After all, putting all your eggs in one basket is never a wise move, especially from a capital protection standpoint. And this holds true even for stocks with a more conservative risk profile, such as dividend stocks.

The key point to drive home is that whether one is planning for his retirement or is merely seeking extra side income, quality is still of paramount importance.

A high yielding stock does not always mean it is a good stock. Though a stock with sound fundamentals and with attractive yields to boot would be a wise investment option.