Dividend-paying stocks give you the security of regular income and historically have outperformed stocks that don't pay dividends. Increasingly, investors who value seeing real money come into their investing portfolios -- whether they need it for living expenses or plan to reinvest it into additional shares -- are turning to dividend stocks.
With dividend stocks, though, having too much of a good thing can cause big problems. Lately, record numbers of companies have been cutting dividends, while extremely few have managed to boost their payouts in recent months. Although you'll find strong businesses like PepsiCo (NYSE: PEP ) and Johnson & Johnson (NYSE: JNJ ) still clinging to their long track record of higher dividends, far too many companies have gone in the other direction.
Stay out of the dividend trap
So how do you foresee companies that could have problems sustaining their dividends? Here are a few warning signs to watch out for:
- Too-high dividend yields. Sometimes, businesses are able to create and sustain truly extraordinary amounts of cash to distribute out to shareholders through dividends. Often, though, you'll find that companies whose stocks have incredibly high dividend yields are in a position where they won't continue paying as much as they have been -- and the market has already started to adjust for that contingency by pushing the stock price lower.
- Unsustainable payout ratios. Another way to gauge whether a company has the financial wherewithal to keep paying its current dividends is to compare them to the amount of earnings the company generates. If a company can't earn enough to cover its dividend payments, then there's a good chance it will have to cut its payouts sometime in the future.
- Limited growth. The best way for a company to afford its dividend payments over the years is to grow its business, creating more available cash and leaving room for dividend payments to increase. Without growth, a company has to rely on its core business continuing to be successful -- something that's far from assured in today's economy.
- Past inconsistency in dividends. If a company has a history of pushing dividends up and down frequently, then you have to take its current dividend yield with a grain of salt. REITs are especially susceptible to this, as they must pay the vast majority of their income as dividends for tax purposes and are therefore vulnerable to swings in annual payouts.
Several stocks that meet some of those criteria, such as Southern Copper (NYSE: PCU ) and Vornado Realty (NYSE: VNO ) , have actually cut their dividends recently. Here are some other stocks that set off alarms:
|
Stock
|
Dividend Yield
|
Payout Ratio
|
Current P/E
|
|
Frontier Communications (NYSE: FTR )
|
14.3%
|
179%
|
12.8
|
|
Altria Group (NYSE: MO )
|
7.3%
|
114%
|
11.7
|
|
Nisource (NYSE: NI )
|
7.1%
|
196%
|
28.0
|
|
Mercury General
|
6.6%
|
N/M
|
N/M
|
Sources: Yahoo! Finance, DividendInvestor.com.
Of course, showing up on this list isn't an absolute guarantee that these companies will actually cut dividends soon -- if ever. Altria, for instance, has a long history of making substantial payouts.
Moreover, if the economy rebounds, then these companies could see their earnings grow dramatically, providing enough income to support dividend yields that will shrink as share prices move up. Nevertheless, it's clear that these stocks are under more pressure than many in trying to keep their dividends at current levels.
Be safe
Picking good dividend stocks is like Goldilocks picking the right bowl of porridge. Obviously, you don't want to settle for a stock that pays little or nothing to its shareholders. But if paying too big a dividend is a promise that a company won't be able to keep in the long run, buying shares will only bring you losses without giving you the benefits of receiving big quarterly checks for years to come.
So if you have dangerous dividend stocks in your portfolio, be careful. You may not need to be in a hurry to sell them, but you shouldn't rely on the good times lasting forever.
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