Be Careful Using Financial Stocks as Dividend Plays

Financial Stocks

Many investors jump on financial stocks with the intention of taking advantage of their better dividends. This is just one aspect of them, and not even the biggest one.

Buying common stock of financial companies is a popular way for investors on the more conservative side to seek to achieve their investing objectives. This isn’t anywhere near a conservative approach as we may think though.

We may convince ourselves that we’re in it for the dividend yields, and the yields with financial stocks may seem pretty tempting in combination with their potential for capital appreciation. In a nutshell, utility stocks pay better dividends but they are famous for their lack of growth potential, which makes sense because these businesses are much more static than your average stock, but financial stocks can pay almost as much and also grow a lot more.

In spite of these investors at least purportedly having dividends as their prime objective, during a bull market like the one we’ve had for the last 10 years, the lure of more capital appreciation is what tempts these investors.

To illustrate how much more tame utility stocks are, since Christmas, the broader S&P 500 is up over 20%. The Dow Utilities index is only up 2% over this time. Utility stocks are much more like preferred stock with a little spice added to them, where you give up a bit in yields to get a little price action potential.

Those who actually do want to just seek out dividend returns often will find preferred stock more suitable, because these stocks don’t really move in price, although you still need to be careful to select ones that will actually deliver the mail the right way as far as their dividend payments go.

This means that their business must be solid and predictable, and in the world of business, this does tend to fluctuate quite a bit at times. It doesn’t fluctuate anywhere near as much as the more whimsical common stock does, which can jump up and down in value quite a bit from even minor changes in the outlook of the company or the stock market.

Common stock does take advantage and be exposed to the disadvantage of the accumulation and distribution of these shares in the market, where if a lot more money is coming into the stock it can go up quite a bit in price, and go down when money is being diverted from the stocks.

Business Performance Define Yields, Investor Sentiment Defines Price

There is a general lack of a proper understanding about how various conditions affect stock returns. With preferred stock, it’s 100% about the business, as what you are earning is a share of a company’s profits basically, with nothing else really weighing in on things. With common stock though, while there is a dividend component as well generally, contributing to total returns, the price of the stock itself is purely influenced by the stock market itself.

This is why common stocks do not just follow dividends, and while company fundamentals certainly influence stock prices, this relationship is a very loose one, and it’s extremely common to see a company continuing to do well and grow but their stock price sink considerably.

Using common stocks primarily to earn dividends involves both, and while we may say that we’re only looking to stay out of the weeds with price valuations, this does not prevent us from being exposed to the higher risk of price fluctuations. Preferred stock takes this right out of the equation, utility stocks greatly mute this effect, but ordinary stocks are quite exposed to this risk, including financial stocks.

If you earn an extra percentage in yields during a year but your stock has declined in price by 10%, you have fallen behind pretty significantly. Many investors try to fool themselves into thinking that since they aren’t planning on selling the stock for years, this all doesn’t matter, but it really does, since this is all about what you did versus what you could have done, the opportunity cost of an investment in other words.

If you could have put your money under the mattress instead, you would have missed out on the dividend but avoided the loss, and this would have you well ahead in this situation. There are better things to do with the money which will produce a positive return, just keeping the money in a cash account for instance, or investing in bonds, preferred shares, or a much tamer utility stock, and while we can tell ourselves that this is the path we have chosen, these alternatives are real and cannot just be tossed out of hand.

We are conditioned as investors to put blinders on and ignore all of the other potential decisions and alternatives out there, but this is clearly the bane of investing. We even forget that the goal here is to seek out success and instead choose stagnant strategies which ignore opportunities to optimize or even improve our success in favor of just sticking to the strategy we have chosen, regardless of how appropriate it may be to the current circumstances and its opportunity costs relative to alternatives.

When it comes to investing in financial stocks for the primary purpose of yields, we cannot escape the risk involved even if we pretend it doesn’t exist or it doesn’t matter. When investing in common stock, it’s always about total return, and it has to be, because when we sell, what we’ve made from dividends and what we’ve gained or lost in price both get fully calculated in.

The risk with this is that we may lull ourselves into thinking that this is fundamentally different from investing in other stocks, since we’re after the higher dividends, and end up ignoring price considerations even more than we generally do with stocks.

With Financial Stocks, Price Potential is Still King

We need to consider the relative role of dividends with common stocks, and as a rule, the capital appreciation side of things is the bigger of the two. If three quarters of your potential return or more will be coming from price increases, then it should be obvious that we need to be focusing most of our attention on the price side, just about all of it in fact, since the fluctuation of dividends pales in comparison to what can happen with price over time.

Financial stocks really took a hit in 2018 in spite of a very good year business wise, which means dividend wise, and the fact that valuations may look nicer now does matter, but really only to dividend potential, and not necessarily price potential.

When the price of a stock is lower, given a certain amount of profit, it will yield more. Price performance is really a different animal though, and is driven by investor sentiment, not so much business performance.

This can be a difficult concept for a lot of investors to get their heads around, investors who may have been in financial stocks for their dividends, see the companies do even better, and be down a lot of money overall on the play. We cannot just look to business performance or dividends with stocks of this nature, ones that are sensitive to the whims of the market, and invest solely or even substantially upon this.

Financial stocks were just terrible generally in 2018, and whether they are more desirable in 2019 has very little to do with what dividends we may expect, and has everything to do with what the stock market thinks about them.

With interest rates not going up for a while, this has more people betting on financial stocks, and the way people bet is what decides price, not substantially but completely.

Some have concerns that lowering rates from here will affect the business performance of banks, and there is some truth in this, but that has more to do with dividends than price. Banks pay interest based upon current conditions, and when rates go down, so does their profit margin.

Rising rates hurt banks as well because the demand for loans go down as the cost rises, but the effect isn’t even close to how this affect their stock prices, due to people essentially being willing to bet less on them in this environment. This is offset quite a bit by banks earning more on their deposits essentially.

Banks usually don’t have much trouble lending as long as the rates don’t go up too much or the economy doesn’t decline too much, so we should have not seen them dive anywhere near as much as they did last year, if not for people just selling the stocks anyway by just looking at rates and acting. This completely explains the poor results of last year, and also explains why these stocks are doing so much better now with the potential for even higher rates being set aside now.

Investing in financial stocks does have its time and place for those who wish to get good yields from their stocks, but the timing of this has nothing to do with the yields. When the conditions aren’t so ripe, when there is more potential to the downside, then stocks such as utilities which do not have anywhere near as much downside potential become more attractive.

We may wonder though why we’re invested in anything that has more downside than upside over a meaningful period, a year for instance, and in this case, preferred shares, which don’t go down in price, can make even more sense.

The most important thing to realize is that we cannot just take one aspect of a stock play, yields, and pretend that this is the only thing to look at when this isn’t even the most important thing. Financial stocks may pay out better dividends than many other stocks but they are still fundamentally a speculative play, with all the risks that this brings, risks that do need to be paid attention to.