Written by Sam Kovacs.

Introduction

As an investor, have you ever questioned the prevailing wisdom of dividend investing? Do you find yourself attracted to stocks that offer little to no growth potential or companies with stagnant dividend yields? If so, you might unknowingly be following a strategy influenced by Warren Buffett’s principles. However, I urge you to reconsider. Let’s explore why dividend investing can be risky and why it’s time to steer clear of certain dividend aristocrats.

The Problem with Dividend Investing

Dividend investing, when done right, can be a successful strategy. However, it is crucial to look beyond the conventional wisdom and understand the potential pitfalls. Many online resources oversimplify the approach, leaving dividend investors at risk of buying overvalued stocks and holding onto them indefinitely. This approach is contrary to the dynamic nature of the stock market, where portfolio adjustments and timely selling can enhance returns.

A common misconception propagated by dividend enthusiasts is the belief that buying quality assets and holding them regardless of price is all it takes to succeed. While it is important to invest in businesses with enduring competitive advantages, the concept of “fair price” is often ignored. Dividend investors often justify high stock prices by assuming that these wonderful businesses will continue to generate value and, therefore, future prices will be even higher. However, this assumption overlooks the importance of buying stocks at a discount to their intrinsic value, something even Warren Buffett endorses.

Moreover, the adherence to the principle of never selling, unless for dire financial needs or when reassessing a company’s long-term prospects, can be detrimental to wealth creation. Stocks that lack meaningful dividend growth or have low dividend yields may not offer attractive income potential, ultimately undermining the goal of passive income generation.

Walmart: So Safe It Hurts (Your Returns)

Let’s take a closer look at Walmart, a popular stock among dividend investors. While Walmart’s dominance in the retail industry is undeniable, it falls short as a dividend stock. With a current yield of just 1.4% and meager dividend growth of 1.8% to 1.9% in the past decade, it offers poor income potential. Investing $10,000 in Walmart today and reinvesting dividends would result in a meager $193 in annual income after 10 years. Clearly, this is not a favorable return for long-term investors.

Furthermore, Walmart’s performance relative to the broader market has been lackluster. Even during the tumultuous times of the past decade, it has underperformed the S&P 500. With 5-year Treasuries offering attractive yields and other consumer staples stocks showing better growth prospects, owning Walmart simply does not make financial sense.

What Makes a Good Dividend Stock?

When evaluating dividend stocks, it is important to consider both dividend yield and growth potential. The ideal dividend stock should either offer a high dividend yield with low growth or a low dividend yield with high growth. The trade-off between yield and growth should be balanced. A good rule of thumb is to aim for at least an 8% income return on your original investment after 10 years.

Take The Home Depot for instance. With a yield of 2.8% and assumed 10% dividend growth per year, a $10,000 investment would generate $947 in annual income after 10 years. This represents an attractive return compared to Walmart’s dismal performance.

Dividend Stocks to Avoid Like the Plague

Now, let’s turn our attention to some dividend stocks that investors should avoid if they truly want to maximize their returns. Dover Corporation, Emerson Electric Co., Colgate-Palmolive, and The Procter & Gamble Company all fall into this category. These stocks either offer low dividend yields, subpar dividend growth rates, or both.

Dover Corporation, despite its diverse range of products, yields just 1.4% with weak dividend growth of 1.2% in the past five years. Similarly, Emerson Electric Co. offers a 2.16% yield with a declining dividend growth rate of 1% this year. Colgate-Palmolive, although it trades at a seemingly cheap price, does not offer attractive income potential with a 2.6% yield and dividend growth averaging around 3%. Lastly, The Procter & Gamble Company, while faring better than the others, still falls short with a 2.57% yield and projected annual income of $539 after 10 years on a $10,000 investment.

Investors should be cautious with these stocks, as their low yields and inadequate growth rates pose significant challenges for generating meaningful income. Aiming for stocks that offer a combination of attractive dividend yields and sustainable growth potential is key to successful dividend investing.

Conclusion: The Flaws of Blindly Following Dividend Investing

The prevailing wisdom of dividend investing, influenced by Warren Buffett’s principles, has led many investors astray. Buying and holding stocks without considering valuation and growth potential can hinder wealth creation. Dividend investors need to be open to adjusting their portfolios and selling stocks when the fundamentals no longer support holding onto them.

Instead of blindly following the buy-and-hold strategy, investors should focus on finding dividend stocks that offer the right balance of yield and growth. This approach will ensure a fruitful income stream in the long run. Remember, stocks serve a purpose in creating wealth, and if they fail to do so effectively, it is essential to switch out for better opportunities.

So, before you base your investment decisions on quotes taken out of context, I encourage you to critically evaluate the viability of dividend stocks and prioritize the potential for income growth over adherence to outdated principles.