Dividends, even at today’s low rates, can supercharge investment gains over the long term. But dividend earnings aren’t usually at the top of the list when U.S. investors consider foreign stocks. Should they be?
While there are some generous dividend payers overseas, like BP (NYSE: BP) yielding nearly 5.6 percent, experts say the role of dividends in non-U.S. stocks is harder to pin down than with domestic issues. Many urge caution.
“In Europe, dividend yields are generally higher in aggregate and are more prevalent” than in the U.S., says Sean Lynch, co-head of global equity strategy for Wells Fargo Investment Institute. He points, for example, to average dividend yields of 4 percent in the United Kingdom, adding that they top 4.3 percent in Australia, versus less than 2 percent in the U.S.
“It may be more accurate to say there is a higher tolerance for non-dividend paying stocks in the U.S., but investors seek higher yield in European markets,” Lynch says.
[See: 7 of the Best Dividend Stocks to Buy for 2018.]
Dividends are a slice of corporate earnings passed on to shareholders, and decades ago dividends were the main reason for owning stocks. During much of the 20th century, annual dividends on the Standard & Poor’s 500 index exceeded 5 percent.
Today it’s below 2 percent, not because companies are less successful but because they instead reinvest profits to boost share prices. They’ve learned that many investors prefer share-price gains, which are taxed only after the shares are sold, while dividends are taxed in the year received.
Also, many companies base large portions of executive pay on stock price gains that may be bigger if profits are used to buy back shares or are invested in plant expansion rather than paying out generous dividends.
But dividends are not to be ignored, as many studies have shown that over decades they can account for 30, 40 or 50 percent of returns. That’s because dividends reinvested in new shares gradually account for a snowballing portion of the portfolio, with shares purchased with dividends producing new dividends that then purchase more shares.
Of course, many older investors rely on dividends for dependable income.
But what works for U.S. stocks may not be the same with foreign ones.
Among the biggest wild cards: currency exchange rates. A dividend paid in a foreign firm’s currency will become more valuable when converted to dollars, or less so, as the exchange rates fluctuate. This is true of profits on shares, too, but investors can control when they realize profits on selling shares, and can consider exchange rates, while dividends come when the firm chooses whether exchange rates are favorable or not.
A weakening dollar makes foreign dividends more valuable, a strengthening dollar makes them less so.
“With the dollar decreasing in value against many other currencies, you get the added benefit of exchange rate gains when the dividends are paid,” says advisor William Stack, author of “The 7.0 Percent Solution.”
[See: 7 Overlooked Large-Cap Dividend Stocks.]
As with U.S. stocks, an especially high dividend can be a sign of trouble like a falling share price, since dividend yield is past year’s dividend earnings divided by current share price. If share price is tumbling, it can easily wipe out dividend earnings, or be followed by a dividend cut as the firm struggles.
Additionally, U.S. investors are typically on the hook for taxes foreign countries charge on dividend payments. At a minimum this can be a headache at tax time, else the U.S. investor will be taxed by the IRS as well. Worse, it can chew at the dividend’s value.
“One drawback is paying foreign taxes on those dividends, even when the shares are inside of an American IRA or other qualified account” like a 401(k), Stack says.
In a report last year on the Vanguard International Dividend Appreciation fund ( VIAIX), Morningstar noted that, “Many foreign stocks tie their dividend payments to earnings.” That means selecting stocks that steadily increase dividends, as VIAAX does, also produces stocks with steadily growing earnings, which is good. But Morningstar added that it also means dividend earnings can be volatile, since earnings wax and wane.
U. S. companies, in contrast, tend to abhor dividend cuts as a sign of trouble, and do everything they can to keep paying and raise dividends from time to time.
Although VIAAX focuses on foreign firms that tend to raise dividends consistently, this does not produce sizeable dividend earnings for the fund; it yields only about 1.7 percent. SPDR S&P 500 ( SPY), an exchange-traded fund that tracks the S&P 500, pays 1.8 percent, and some funds that emphasize U.S. dividend payers offer a good deal more. SPY has an expense ratio of 0.06 percent, or $6 per $10,000 annually invested.
An analysis on Dividend.com points to several issues U.S. investors need consider with foreign dividend payers:
Some countries such as Australia and Austria have especially high tax withholdings on dividends paid to foreigners, while others don’t tax them at all. U.S investors can avoid being taxed by the U.S as well, but it takes careful accounting on the tax return.
[See: 7 Utility Stocks with Powerful Dividends.]
Many foreign markets are not as liquid as the U.S. markets. If your generous dividend payer falters, you might have trouble bailing out.
Add to these dividend issues the general issues of foreign stock investing, such as less-revealing financial disclosures and risks of political and economic instability, and the lesson is clear: U.S investors should tread carefully when considering foreign stocks, and not count on the same steady dividend income they might get with U.S. issues.
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Why Foreign Stocks May Not Be Best for Dividends originally appeared on usnews.com
