With yields persisting close to their lowest points in three decades and interest rates likely to rise, fixed income is a challenging place to be. So it’s not difficult to understand why an investor in search of income might be drawn to a banner company bearing a high-yield dividend stock. A regular 4% payout or higher can be a significant boost for income-starved investors.
However, investors shouldn’t be misled into thinking these dividends are the optimal choice for generating consistent income. Companies with high dividends may have overvalued stock prices that are vulnerable during bouts of volatility or interest rate hikes – and, rarely do their dividends turn out to be “regular.”
The mistake investors frequently make is to view the high dividend in isolation, seizing on the attractive payout while failing to appreciate the range of risks that come with it. That is, investors who only consider the dividend could expose themselves to equity risk if they don’t also analyze the company fundamentals. As an illustration, we have to look no further than recent developments at General Electric (GE). GE’s stock price dropped roughly 35% this year, with profits hit by restructuring costs and poor performance. Cash flow problems emerged, and on Monday, GE said it was slashing its dividend by 50% to 12 cents a share from 24 cents. The stock’s blue-chip status is now in jeopardy.
That means those scouting the market for high dividends should carefully evaluate prospective companies for their growth potential and for the presence of any “red flags.” They should also consider broadening their search to include other dividend-yielding stocks — quality stocks that may not have the highest income.
We know companies are encouraged to keep their share prices high. We also know that a dividend cut can wreak havoc on a stock price. And, we have learned that a company in financial peril can help keep its share price afloat by either increasing its dividend or maintaining its already high dividend, thereby preserving the appeal of a large payout while starving its business units of much-needed investments — essentially creating the illusion of financial health.
Setting aside companies that have cut dividends, we can compare the two remaining categories of “dividend payers,” companies with stocks that pay high dividends, and “dividend growers,” companies that have increased dividend payments each year for multiple years. In short, investors should not exclude the growers for the sake of the payers.
Empirical evidence shows that companies with consistent dividend growth tend to outperform those with high dividends. Dividend growers typically have high-quality stocks with a strong history of outperformance, even during periods of market turmoil. Payers, on the other hand, often belong to sectors that allow generation of high cash flows, such as utilities, financials, energy and basic materials. Those companies often leverage that cash flow, sometimes by borrowing aggressively in the marketplace. The high dividends, ultimately, are less an indication of financial strength than they are simply a result of a financial efficiency in the balance sheet.
Accounting practices can serve as a cover to help a company mask an underlying weakness, usually until earnings growth slows or the economy takes a turn for the worse. A sluggish economy or market correction could force payers to cut their dividends. Price returns suffer as the marketplace anticipates the move. Borrowing also makes payers particularly sensitive to rising interest rates since their cost of capital increases when rates rise, ultimately hurting their earnings.
Investors disposed to high-yield dividend stocks should determine if the dividends are being manufactured through financial leverage. They should ensure there is a sound management team in place and then review how it manages cash. They should consider whether the company has the growth prospects to sustain the dividend, and whether the dividend could survive a volatility spike, market distress, or lower earnings growth with its lower margin of error due to the higher leverage.
The pool of dividend growers can be further funneled by filtering for companies that have consistently increased their dividends for a number of consecutive years, scaling up from five years to 10 years to 25 years. As we approach the 25-year mark for consistent dividend growth the pool of companies becomes increasingly smaller, leaving a select group that has demonstrated a sound business model, a strong balance sheet, solid management, revenue growth potential, consistent earnings generation and a high return on equity. These companies have achieved a lasting competitive edge and are positioned to produce consistent income and demonstrate an ability to withstand market volatility. Growers also tend to be more resilient during rate hikes since their earnings growth is not tied to financial leverage.
In today’s market, advisors know that investors’ appetite for anything throwing out yield is attractive, as they’ve eagerly looked to dividends to set off underperformance from the fixed income part of their portfolios. With these high-yield dividend stocks, the burden remains on the investor to conduct a fundamental analysis. It’s easy to become distracted by the higher yield, but history has shown us that the payers aren’t sustainable and that growers embody a quality that can’t come from creative accounting alone.