It's scary out there for dividend investors.
Even with the recent rally, dividend yields are sky-high. According to Capital IQ, there are 1,316 stocks on our major exchanges that have yields of 5% or more. But a lot of these are dividend traps, enticing us with the promise of fat quarterly payouts only to cut them down the road.
As a stark reminder, we can look to General Electric. Once hailed as the safest of the safe, GE has in short succession gotten government help, cut its dividend to save cash and (hopefully) retain its AAA debt rating, and then lost that AAA status anyway.
And of course, relatively conservative banks like BB&T
The "5% of nothing" club
Traditionally, a 5% dividend yield has been eye-popping enough to elicit fears of a dividend cut. Now, it feels commonplace. When you see a blue chip like Kraft creeping up on a 5% yield, anything short of double digits starts to feel safe. And we start getting a little greedy.
But that greed can turn right back into fear if the great double-whammy curse of high-yielding stocks kicks in. After all, we buy dividend stocks because they provide a large, steady stream of income and have the promise of stock price appreciation. But then:
- In this environment, a susceptible high-yielding company's share price takes a beating. (Whammy!)
- In order to preserve precious capital, said company cuts or altogether eliminates its dividend, destroying dreams in the process. (Double-whammy!)
As a result, I view any dividend yield as a "too good to be true" situation until I've fully vetted the company. It's a good default stance on any stock you're considering buying. Let's take a quick look at some companies with plus-5% dividends to illustrate:
|
Company |
Dividend Yield |
Payout Ratio |
|---|---|---|
|
BP |
7.4% |
63% |
|
Dupont |
6.8% |
115% |
|
Limited Brands |
5.2% |
158% |
|
Barnes & Noble |
5.1% |
75% |
|
Paychex |
5.1% |
84% |
Source: Capital IQ, a division of Standard and Poor's.
The story behind the numbers
The first thing I do when I see a tasty dividend is look for obvious problem areas. If I can spot a major problem quickly, it saves me further research.
Notice the payout ratios (the percentage of earnings a company pays out in dividends) in the table above. If I see a payout ratio greater than 50%, I get suspicious. When the payout ratio goes above 100%, that means dividends aren't currently being covered by earnings.
So, the first thing I notice is the above-100% payouts of Dupont and Limited Brands. If you believe Dupont's restructuring charges this year are a one-time event, its dividend appears high but sustainable. It has good interest coverage and a reasonable balance sheet. Limited has lower coverage on its debt, a higher payout ratio, and a difficult retailing environment to contend with.
Of the other three, Barnes & Noble gives me the most pause. It has a clean balance sheet, has been consistently (if decliningly) profitable, and has more free cash flow than income, but I can't get over the long-term competition it faces from Amazon.com
Which dividends will survive?
It's darn hard to determine the sustainability of dividends in this environment. Due diligence is important in any environment, but it's especially important now, when we can scoop up high-dividend plays that could form the core of our portfolios for decades to come.
The team at our Income Investor newsletter does their homework. They look for the most stable companies that pay the highest, most sustainable dividend yields. They actually recently took Kraft off their list of recommendations, not because it's a bad company but because they see better opportunities out there. For new money, they rank six sustainable dividend-paying stocks as "buy first" candidates. You can see all six, and try out the entire service, for free with a 30-day trial. Click here to learn more -- there's no obligation to subscribe.
This article was originally published on May 7, 2009. It has been updated.
Anand Chokkavelu doesn't own shares in any company mentioned. In his spare time, he hosts a snack-food program called "These Doritos are Done." Paychex is an Income Investor selection. Amazon is a Stock Advisor pick. The Fool has a disclosure policy.
