If you have been struggling to generate enough income from your investment portfolio lately, then dividend stocks have been just about the best way to get the cold, hard cash you need. But before you simply accept the conventional wisdom about why dividend stocks are superior to other types of investments, you should keep in mind that in certain circumstances, dividends have almost nothing to do with the fundamentals of a business.
Why investors love dividend stocks
In general, there's good reason for investors to gravitate toward dividend stocks. Historically, stocks that pay dividends have had better performance than their non-dividend-paying counterparts. One possible reason for dividend stocks' outperformance is the simple fact that most stocks that pay dividends have cash-generating businesses backing those payments, with the most successful dividend payers having particularly stable free cash flow to finance payouts.
But just because solid businesses tend to produce lucrative dividends doesn't mean that companies that pay lucrative dividends all have solid businesses. Let's take a look at two situations in which dividend stocks can be downright dangerous.
Case 1: A deteriorating business
Often, a stock that used to be a solid dividend payer runs into tough times. For temporary problems, most mature companies can ride out the tough times without making dividend cuts. But when the situation gets dire, sometimes a dividend cut is the only alternative.
We've seen an increasing number of those situations lately. Cliffs Natural Resources (NYSE: CLF ) , for instance, slashed its dividend by three-quarters after realizing that the slump in iron ore and metallurgical coal prices simply wasn't going to end soon enough for the company to sustain its payout to shareholders. The dividend cut helped Cliffs conserve cash, but low prices have also led to some key moves for its underlying business, including the idling of production plants that will further hurt its revenue.
Pitney Bowes (NYSE: PBI ) also became a victim of a dividend cut as it chose to reduce its payout by half in order to help it conserve cash as its financial results have deteriorated. With the very difficult task of repositioning itself from the largely obsolete postage business to become a more full-service enterprise communications company, Pitney Bowes will need as much spare cash as possible to reinvest in its new business opportunities.
Case 2: Artificially high payouts
In other situations, dividend stocks make payouts that aren't based on earnings or other income at all. Rather, they seem manufactured simply to appeal to income-hungry investors.
The rash of special dividends we saw late last year was a particularly good example of this phenomenon. Costco (NASDAQ: COST ) chose to make a payout of $7 per share late last year, noting that the company had more than enough cash to cover the dividend. Yet the company ended up borrowing money in order to help finance the payout, tripling its outstanding debt.
Some companies even make their regular dividend payments by raising capital, either from debt offerings or by selling new shares. Utilities PPL (NYSE: PPL ) and Southern (NYSE: SO ) have used this strategy for years, as capital-intensive operations often make it necessary for utilities to find sources of cash elsewhere in order to give investors the dividends they've come to rely on.
Beware of dividends
Of course, thousands of dividend-paying stocks are perfectly good investments, so suggesting that all dividend stocks are dangerous is a gross exaggeration. But before you assume that any dividend stock is automatically healthy, you need to be aware of these potential pitfalls that can trap unwary dividend investors.
Costco's low prices haven't just benefited customers -- shareholders have walloped the market, returning 11,000% over the past two decades. However, with prices near all-time highs, is the ride over for Costco investors? To answer that and more, The Motley Fool has compiled a premium research report with in-depth analysis on Costco. Simply click here now to gain instant access to this valuable investor's resource.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.