As you know, dividends are one of the primary points of focus of the Rebel Income and Retirement Revival investing systems. I’ve written in the past about why I think dividends should be an intrinsic part of a successful income generation system, and why dividend-paying stocks generally have a stronger fundamental profile than stocks that don’t pay a dividend. I’m calling today’s article a “deep dive” because I’ve noticed a lot of buzz in the media lately about high-dividend stocks. There’s a real temptation to focus on stocks paying the highest dividends possible, but the truth is that sometimes that high dividend is really a warning sign of risks that you need to be aware of.
Why High Dividends May NOT Be A Good Thing
At first blush, this might sound a little silly. Why wouldn’t you want to jump on a stock offering a nice, fat dividend? Since dividend payments have to be approved by a company’s board of directors, and they have a direct impact on a stock’s bottom line (they are listed in the cash flow portion of an earnings statement as a negative item), it stands to reason that dividends should only be paid when the company has a healthy, stable cash flow and can distribute a dividend to shareholders without impacting other business operations. Of course, this is really just a very broad generalization; the truth is a little different.
First, let’s consider what a “high” dividend generally is. The simple approach is to compare a stock’s dividend yield to the yield you can get from other instruments, like CDs or Treasury notes. Right now, for example, a 5-year Treasury note is offering a yield of about 1.72%. To me, that generally means that a stock offering a dividend yield between 1.5% to 2% is inline with that benchmark. Stocks with dividends higher than 3% would fall into what I call the “high-dividend” category. There are a couple of reasons a stock’s dividend might fall into this category: either a company has intentionally raised their dividends to these levels, or the stock’s price has fallen low enough relative to the annual dividend payment to raise its yield.
Keep in mind that any business, no matter what industry or economic sector they may exist in, experiences ebbs and flows in their operations. Profitability can often be a fluid thing. And so while we have the “best case scenario” I’ve just described for a company to deliver value to its shareholders, that isn’t the only time dividends get paid. A company with a long, established history of consistent dividend payments, for example, will usually do everything they can to keep those dividends going even in tough times, because their shareholders are counting on it. The stability of that dividend payment, in that case, is usually a hallmark of the company that keeps shareholders happy and loyal.
Companies that pay a dividend in sectors with a higher level of sensitivity to economic conditions (oil and energy in general are just two of the most recent, visible examples) tend to be an exception to the rule in that industry. The volatility of that sector’s profitability at any given time can make a dividend harder to sustain.
Over the last year or so several of the oil and oil-related stocks I’ve used for put selling trades, and have held, have drastically cut their dividends to preserve cash, or in some cases eliminated it altogether. Dividend purists tend to take these actions as uniformly negative, but I prefer to consider them on a case-by-case basis. Is the dividend being cut because the company has no other choice, or are they trying to be proactive in preserving their cash flow? I think the difference between these two situations matters, and in many cases I’ll keep working with a stock even as it cuts its dividend if I think the latter applies.
To be clear – I don’t take a high dividend yield as automatically a bad thing. Like everybody else, when I find a great company with generally great fundamentals and a nice value profile, an inflated dividend yield is a nice bonus. This week I surveyed 250 out of the 500 stocks in the S&P 500 index (frankly, I ran out of time to do the other 250) to identify the highest dividend-paying stocks from that list. Here’s a sample of the top 10.
The conservative side of me, which tends to serve me pretty well as an investor, generally makes me cautious, and even a little suspicious when something starts look “too good to be true.” It’s a big reason I’ve learned to shy away from extremely speculative, high-risk trading strategies and markets. As an income investor, seeing outsized dividend yields (even higher than the 3% I set earlier as my “high-yield” watermark) starts to make me twitch a little bit. The question is how to determine if that twitch is correct, or whether a very high-yielding stock might actually have a good opportunity. This is where the “Payout Ratio” column on the far right starts to come in handy.
Dividend Payout Ratios
Payout ratio is a straightforward calculation: just divide the dividend per share paid over the most recent twelve month period to the earnings per share over the same period. A ratio of 1 means the company paid as much in dividends as they claimed in earnings per share. If you think of earnings as a reflection of profit, it makes sense that this ratio should generally be less than 1, and the lower the number, the better.
Now, payout ratios in and of themselves don’t really imply much, if anything, about why the number is what it is. I can’t look at a stock’s payout ratio and immediately say that because it might be higher than 1 that the company is in trouble (remember, just as a company’s fortunes will ebb and flow, this number will, too). A stable, fundamentally strong company with a history of consistent, stable dividends, and a strong cash position may choose to keep a dividend high even as profits decline during a period of economic difficulty.
They’ll pay their dividends from available cash because they’re confident not only that they can maintain the dividend, but also that they’ll be able to ride out whatever the current conditions are. That’s why seeing stocks like T, CTL and DUK with high yields and payout ratios just a little below may not necessarily be a bad thing.
What about the company at the top of the list, FTR? Talk about an outsized dividend – at the stock’s current price, its yield is above 12%! The payout ratio might look like a typo, but it really isn’t. I dove into this stock’s fundamental profile in more detail, and the picture really isn’t pretty. This is a company with massive debt, dwindling cash reserves, and no (I do mean zero) operating earnings and negative cash flow. This company’s board should have suspended its dividend a long time ago, and why they haven’t is beyond me. This stock falls into my “a ten-foot pole isn’t long enough” avoidance category.
While payout ratios above 1 aren’t common, they do happen. Of the 250 S&P 500 Index stocks I surveyed, I found 7 with current payout ratios above 1. Here they are.
It’s interesting to me that of the 250 stocks I surveyed, so many of the stocks paying more in dividends than they have earned came from the same sector of the market – energy. CVX, HAL, and XOM all have direct ties to oil. And while by themselves, these payout ratios don’t automatically equate to fundamental weakness, they do act as a red flag that prompts me to look more closely at each company before I decide whether it’s worth using it for an income-generating trade.
I’ve held HAL for two full years now. They are a good example of why a higher payout ratio isn’t necessarily a bad thing. This is a company that has been dealing with declining earnings for more than a year; but they didn’t see their trailing twelve-month EPS drop below their dividend until last quarter. And while it isn’t a great thing that their dividend, which has not been lowered throughout, will for the time being draw down their cash flow, I think this is a case where the maintenance of the dividend is a good indication of the management’s confidence in the future, which is just another indication that confirms the reasons I have continued to hold the stock despite the difficulties of the last two years.
I really like dividend-paying stocks. I like stocks that pay a higher dividend than what you can draw in interest from bonds or other interest-bearing instruments. I try to be careful about jumping onto stocks with unsustainable dividends, however, or that may be sacrificing important parts of their business to keep a dividend attractive. That’s why most of the stocks I work with in my Retirement Revival and Rebel Income systems aren’t on the high end of the dividend yield curve. The fact a high payout ratio is a rarity, to me is an indication of why these types of stocks often carry more risk than they are worth.