Three months, get a dividend check. Three months, get another dividend check.
It’s the lather-rinse-repeat cycle of the American income investor — a routine as old as dividend investing itself. That’s because most U.S. dividend stocks pay a quarterly distribution in concert with their regular financial results. “What’d we earn? Does that cover the checks? Great. Send them out!”
Not every dividend stock works this way, though. Many international stocks pay irregular biannual dividends. Some even pay just once a year.
And a handful of stocks march to the more frequent beat of a different drum.
Monthly dividend stocks are a rare breed of stock that has enough visibility in its earnings and cash situation to be able to pay out distributions on a monthly basis.
On the surface, it’s a swinging deal for investors.
[Read: Why Warren Buffett Loves Buy-and-Hold Stocks.]
“A monthly dividend is a fantastic arrangement for investors because it more closely aligns with their expense cycle,” says Charles Sizemore, a portfolio manager on Covestor and chief investment officer at Sizemore Capital Management in Dallas. “Your bills are monthly, so getting your dividend monthly is convenient.
Like many things, however, monthly dividend stocks’ wide theoretical appeal isn’t perfect in practice.
The numbers do add up. Let’s give monthly dividend stocks credit where credit is due: They have math on their side.
“If you reinvest your dividends, they compound faster if reinvested monthly rather than quarterly,” Sizemore says.
For example, let’s say you owned a 100 shares of a $1 stock that, all told, paid out $5 a year in dividends, but only via a lump-sum distribution at the end of the year. If you reinvested that $5, you’d have $105, which would lead to $5.25 in income the second year, bringing you to $110.25.
Now let’s say you owned another $100 stock that paid out $5 a year in dividends, but spread over 12 monthly payments. Every month, you could sock that small bit of income away and reinvest it, then earn slightly more in dividends each month. So, $100 would become $100.42 in the first month, then $100.84 in the second. By the end of the first year, you’d have $105.12. By the end of the second, you’d have $110.49.
Granted, this example would require buying partial shares, which you can’t. So now let’s switch to a more realistic situation.
Let’s say you bought 2,000 shares of a $50 stock that pays $2.50 per share (so, a 5 percent yield) once a year. Even if the stock doesn’t appreciate and never grows its dividend, after 30 years, comes to $432,194.24, or 332.19 percent. A quarterly dividend stock with the same yield would return $444,021.32, or 344.02 percent. But the winner is the monthly dividend stock, at $446.774.43, or 346.77 percent.
Considering 30 years of compounding, the outperformance is slight. And sure, no one would cough at an extra $2,700 come retirement time.
But that $2,700 is hardly free.
Frequency or quality? Monthly dividends aren’t exactly commonplace. In fact, they’re mostly limited to a few asset classes that, coincidentally enough, are high-dividend in nature, too. Real estate investment trusts, business development companies and occasionally master limited partnerships will pay out monthly dividends.
The problem is, the very nature of these businesses that allows for monthly dividends also creates additional risk.
“On average, monthly dividend stocks feature middle- to low-type dividend health,” says Eric Ervin, co-founder, president and CEO of Reality Shares, which analyzes dividend stocks for his company’s series of income-focused exchange-traded funds. “They’re not the strongest, they’re not the most likely to grow their dividends, and they’re a bit more risky in that regard. They pay a higher percentage of their overall income in dividends, so if income goes down, they’ll have more risk to the downside.”
Ervin pointed out the example of American Capital Agency Corp. (ticker: AGNC), which not only has lost about 30 percent of its value over the past five years, but has cut its dividend in each of those years — including a cut to its monthly dividend from 20 cents per share to 18 cents effective in August.
Adam Johnson, author of Bullseye Brief, is particularly wary of REITs, which he says face a “triple whammy” of headwinds right now.
[ Read: 9 Steps a Single Person Can Take for Retirement.]
“One, rates are ultimately going to go higher, which means their borrowing costs go up. Two, a lot of the real estate that has been developed over the past three to five years have been financed at 3 percent to 4 percent cap rates, so you have to hold the property for 30 years at full occupancy to get your money back. And three, REITs have attracted more money flow than any sector year-to-date by a long shot.”
“I wouldn’t touch anything REIT-related right now.”
Closed-end funds — essentially mutual funds that trade on an exchange, but have a limited number of shares — are another monthly income option. Because these are funds consisting of many holdings, they’re not subject to the same type of single-stock risk you expose yourself to via individual monthly dividend stocks. And they’re often used for high-income strategies such as junk bonds, covered calls or high-yield equity.
But even these have their dangers.
“While relatively high monthly income is a plus, investors need to look at the distribution and return and see how it is being generated,” says Ron McCoy, portfolio manager on Covestor and chief investment officer at Freedom Capital Advisors in Winter Garden, Florida. “Is it through cash flow or a return of principle? Additionally, do they use leverage and if so, how much?
That leverage McCoy is referring to is when CEFs borrow money at low rates and reinvest it to generate a higher return than that rate.
“It’s a double-edged sword and works fine when rates are dropping,” McCoy says. “But when rates do rise, many of these funds that use leverage will drop in value. Investors should be aware of that risk.”
The takeaway here is that monthly dividend stocks are much like high-yield stocks in that they’re not inherently good or bad — they need to be looked at case by case.
“You should look at whether a stock pays a dividend, and whether it’s sustainable,” Ervin says. “Look at quality of business, regardless of whether the dividend is paid out quarterly, monthly or annually.”
[See: 11 Stocks That Donald Trump Loves.]
“Monthly dividends are nice to have, but they’re definitely a red herring.”
More from U.S. News
13 Money Hacks to Turbocharge Your Investments
Oil ETFs: 8 Ways to Invest in Black Gold
8 ETFs for Investors Who Love Value
Why Investors Should Love Monthly Dividend Stocks originally appeared on usnews.com
