If you are like me, you love a good dividend stock. There's nothing better than sitting back and collecting a quarterly dividend, especially if the stock in question is offering a big yield. But there are a few things you need to know before you pull the trigger. Plains All American Pipeline, L.P. (PAA 1.90%), Hormel Foods Corp (HRL 1.00%), and Magellan Midstream Partners, L.P. (MMP) will help explain three key facts every dividend investor should know.
1. Sometimes there's a good reason for that high yield
Plains All American is a midstream oil and natural gas partnership. It has been increasingly shifting its business toward fee-based assets over the past decade via construction of new assets and acquisitions. In fact, at the company's investor day, Plains All American projected that fees would account for 90% of its revenues in 2017. It would be reasonable to assume that this is a fairly stable business if you didn't look any further. So when the yield spiked over 9%, you might have been tempted to jump aboard.
Image source: Getty Images.
That high yield showed up after the partnership reported it had a tough first quarter in early May. At that time, however, management was calling for improving results through the rest of the year. Then during the second quarter call in early August, management noted that it was reviewing its distribution policy. The yield spiked to over 11%. On August 25, it announced plans for a distribution cut -- the second in roughly a year. One of the big problems the partnership was dealing with was the heavy debt load left from its expansion and acquisition activity.
The takeaway here is that sometimes high yields show up for a good reason. In Plains All American's case, investor concerns about a distribution cut that pushed the yield higher turned out to be true. Important fact No. 1: Don't get suckered in by a high yield; do your homework.
2. Think in relative terms
As long as you understand that a high yield requires that you dig a little deeper and examine everything with a cautious eye, then dividend yields are a useful indicator. But you can't just look at one data point. One day's yield, even if it's high on an absolute level, doesn't tell you a whole lot.
Take Hormel Foods and its roughly 2.1% yield. That doesn't sound like a high yield at all, but if you look at the company's historical yield trends, it is. The yield has spiked higher on occasion, like during the 2007 to 2009 recession, but a yield of 2% or more has historically been a buying opportunity. The same could have been said for industrial giant Emerson Electric (EMR -0.46%) when its dividend yield spiked over 4% in late 2015 and early 2016. Emerson has since rallied, and the yield is now below 3% -- closer to the middle of its historical range.
HRL Dividend Yield (TTM) data by YCharts
But are these signals or warning signs? That's where homework comes in. Hormel is dealing with industrywide headwinds today, as was Emerson in late 2015. There's really nothing to suggest that Hormel's dividend is at risk today or that Emerson's was at risk when it spiked to the high end of its historical range. Important fact No. 2: Look for high yields relative to historical yield trends -- even if that means lowering your yield targets.
3. Don't forget dividend growth
When looking at high-yield stocks, you can't forget about the future. A high yield backed by a dividend that doesn't grow will slowly get eaten away by inflation. That's a big problem if you hope to live off of your dividend income and still have 20 or more years of retirement ahead of you.
But there's more to this issue. If you are willing to sacrifice some yield today to invest in a company that has a higher dividend growth rate, then you could actually end up with more income down the road. For example, Magellan Midstream Partners offers investors a yield of around 5% today. Larger and more diversified Enterprise Products Partners L.P. (EPD 0.18%) has a yield of nearly 6.5%. You might be tempted to go with the higher yield since the two are very similar. However, take a look at the graph below and you might change your mind.
EPD Dividend Per Share (Quarterly) data by YCharts
Over the past decade, Magellan has grown its distribution at around 11% a year on an annualized basis. Enterprise's distribution growth was around half that. You can see what a difference that makes over time. Over the next few years, Enterprise is expecting distribution growth in the low single digits; Magellan is targeting 8%. Unless you need to maximize income today, Magellan, despite a lower yield, is probably the better option right now. Important fact No. 3: Dividend growth matters as much, if not more, than a high yield.
Think before you leap
The really big picture here is that a big, fat, juicy dividend yield is great, but not enough to make an investment decision. The yield could be high because a dividend cut looks increasingly likely, like what transpired at Plains All American. And you can't look at yield in a vacuum -- sometimes a low absolute yield can be a high yield for a specific company, like Emerson in 2016 and Hormel today. You might find some diamonds in the rough if you look at high yields a slightly different way. And then there's the issue of dividend growth, which can make a lower yield today more attractive over the long run, as the comparison between Magellan and Enterprise makes clear.
