Dividend Stocks Aren’t Just for Income Investors. Here’s Another Reason to Buy Them.

(Dreamstime)

Key Points

• Most investors in dividend funds, approximately three-quarters, automatically reinvest their payouts rather than withdraw them for income.
• In the 1990s, buying stocks with higher yields led to outperformance. That hasn’t been the case lately, with low- or no-yielding tech stocks leading the market.
• Dividend-paying S&P 500 companies, like UPS and Pfizer, are value stocks yielding an average of 4.5% and trading at 19 times forward earnings.

Dividends aren’t just for income investors. In fact, they may be among the minority buying income-focused stocks and funds.

The entire fund industry orients products to different types of investors. Want to invest in rare-earth materials or space? There are funds for that. Want to double or triple a bearish bet against Tesla? There are funds for that, too. Income-seeking investors have exchange-traded funds such as Vanguard High Dividend Yield and Schwab US Dividend Equity, while investors primarily seeking capital appreciation have options such as the Vanguard US Growth fund or the SPDR S&P 500 ETF.

That’s not quite how it works in practice. Sharon Hill, Vanguard senior portfolio manager and head of equity global and income, notes that on days when the funds she helps manage, including Vanguard Equity Income, were due to pay out dividend income, she didn’t have to raise capital to fund it—something that should have happened if investors were taking the money and using it elsewhere. “I thought, ‘I wonder why that is?’” Hill says. “And the answer is because most of our investors have an auto-reinvest feature turned on.”

It turns out that income-oriented investors are no more likely to withdraw dividends than those in ordinary equity funds, with some three-quarters of the former opting to reinvest their payouts.

Wanting to know more, Hill reached out to Vanguard’s clients, collecting some 5,000 responses to help solve the puzzle. She discovered investors view dividend-paying funds as a way to diversify their portfolios. Dividend-paying companies are different kinds of stocks from those with no quarterly payouts. The highest 20% of dividend yields in the S&P 500, including stocks such as United Parcel Service and Pfizer, are value names, older businesses that yield an average of 4.5% and trade for an average of 19 times 12-month forward earnings, while the roughly 100 stocks in the index that don’t pay a dividend— Amazon.com and Palantir Technologies among them—trade for an average of 36 times estimated earnings.

Hill also found investors think companies that pay a dividend care more about their shareholders, are more “trustworthy,” and “better stewards of capital.” There is some reason for that. In the 1990s, buying stocks with higher yields led to stock market outperformance. That hasn’t been the case lately, however, with low- or no-yielding technology stocks leading the market.

Interest rates can impact dividend payers differently. In theory, a steepening yield curve, the situation investors find themselves in today, benefits higher-yielding stocks more than lower-yielding companies. Stocks aren’t bonds, but a higher-yielding stock looks that much better when money-market rates are falling, if long-term bond yields don’t budge.

It’s not as if investors are averse to having income if they need it. Vanguard found that the option of having cash if needed is another reason cited for buying high-yielding funds, even if investors don’t need it immediately. Of course, they can sell shares or funds to raise capital, but the assurance of quarterly payouts helps investors get over the fear of being forced to sell when shares take a dip.

Regular payouts aren’t cost-free. Dividends are taxed whether they are reinvested or not, says accounting expert Robert Willens, though that can be offset for long-term investors because they also raise the cost basis of a portfolio position, softening the tax burden down the road when the asset is sold.

If dividend funds aren’t only for dividends, then investors—and fund managers—should make sure to pay attention not only to the size of the yield, but to the quality of the companies in any actively managed dividend fund as well.

Quality diversification is, after all, what most investors really want.

Write to Al Root at allen.root@dowjones.com