The Perils Of The Safe Income Illusion

Here’s Josh Brown with a good piece on dividends. He asks, “are we too obsessed with dividend income?” Tricky question, but I would tend to answer by saying that, when we substitute equity income for bond income, we’re often searching for “safe income” in all the wrong places.

As I noted in a recent piece, corporations don’t have to pay out dividends and we should expect capital appreciation to accurately reflect the true value of shares regardless of dividend payments over time. But a lot of asset allocators prefer to get income because they enjoy the optionality of dividend payments as well as the sense of security this provides.  This is fine, but we have to be careful here.

The problem with dividend investing often arises when we start assuming that common stock or similar instruments are “safe” in the same manner that most bonds are. That can be a problem with common stock allocations because we often find that common stock dividends get cut during times of distress (exactly when income paying instruments should provide you with safety). In other words, just because a corporation says they’ll pay a dividend doesn’t mean they actually will.

Think of it like this.  Lets’ assume Corporation XYZ is expected to earn 10% in profits for the next 10 years.  If they promise 3% of those profits in the form of a dividend then they’ll pay out 3% every year in what looks like safe income.  You should expect to earn something close to 7% in capital appreciation over the long-term in addition to this distributed dividend.  The problem is, those profits aren’t guaranteed therefore the dividend isn’t guaranteed either.  So, let’s say our corporation suddenly can’t generate a profit.  In an effort to reduce the bleeding one of the first things they often do is cut dividends.  They’ll certainly do this before defaulting on bondholders so the bond income is inherently safer than the equity income.  Dividends often amount to promises that can’t be kept.