3 Deadly Dividend Stocks to Avoid

Dividend investing is all the rage. And what's not to love? Getting those four (typically) payments each year feels great for investors. It gives you a tangible affirmation that you're actually getting something out of owning those little pieces of paper sitting in your brokerage or retirement accounts. And beyond the positive affirmation those payments provide, research indicates that companies that pay dividends outperform the market. All in all, dividend investing seems likes an ironclad road to riches.

Unfortunately, not all dividends are created equal. And in that spirit, I want to highlight some indicators and examples of the wrong types of dividends.

Buyer beware
A high yielder can become deadly when its payout is so high, the company can't afford it anymore. When a company's payout ratio begins to rise about 75%, it's worth taking note. Such a high payout ratio means that the company in question pays more than three-quarters of its income out to owners. While this might sounds like an investor's dream (and not always a negative), such practices can also give companies very little breathing room in running their businesses, especially since evidence indicates firms will often go to destructive lengths to avoid cutting their dividends.

Keeping that in mind, let's look at three firms with dangerous dividends:

Company Name

Dividend Yield

Payout Ratio

Dividends Per Share (LTM)

Diluted EPS Excluding Extra Items

DHT (NYSE: DHT  ) 9.9% 155% $0.40 $0.25
Navios Maritime (NYSE: NMM  ) 8.6% 122% $1.70 $1.37
Himax (Nasdaq: HIMX  ) 11.6% 171% $0.25 $0.15

Source: Capital IQ, a division of Standard & Poor's.

Looking at these figures reminds of me of the famous Warren Buffett quote, "You don't know who's swimming naked until the tide goes out." While stocks paying out dividends in excess of 5% sounds amazing on paper, these eye-popping yields don't necessarily indicate safety. Each of these companies paid more out to their owners than they made last year.

While investors always love companies that pay consistent dividends, they generally prefer their firms avoid burning into their cash stores in order to keep the checks coming. Companies that find themselves in this situation usually have some kind of headwind affecting them and decide to maintain payouts in hopes that normal business conditions will eventually return. However, if those headwinds remain intact, such companies often need to reduce the size of their payouts. Such negative developments can sink investments.

The safer side of dividends
Contrast the stocks above with traditional stocks with histories of paying strong, consistent dividends:

Company Name

Dividend Yield

Payout Ratio

Dividends Per Share (LTM)

Diluted EPS Excluding Extra Items

Johnson & Johnson (NYSE: JNJ  ) 3.4% 48% $2.16 $4.41
McDonald's (NYSE: MCD  ) 3.0% 48% $2.32 $4.73
Diageo (NYSE: DEO  ) 3.0% 53% $0.61 $1.14
H.J. Heinz (NYSE: HNZ  ) 3.4% 59% $1.77 $2.98

Source: Capital IQ.

The discrepancies between these two tables demonstrate the difference between chasing yield and investing for income. The dividends in the first table appear to be on thin ice. The companies in the second table pay above-average yields while maintaining conservative payout ratios. Such old-school policies enable companies to keep those payments coming year after year. Keeping more normal payment schedules also enables these firms to invest spare cash back into their businesses, which can in turn lead to dividends that grow as time passes (another big plus for investors).

Trying to capture greater gains by taking on additional risk can hamper your performance over the long run. Investors only need to think back a few years to remember how "too good to be true" investments typically end. While we love high dividends, it's important to ensure that those payouts are also safe. Doing so could make the difference between a happy retirement and a few more years in the rat race.

If you like some more help finding safe dividend payers, The Motley Fool compiled its very best dividend ideas in into one special report "13 High-Yielding Stocks to Buy Today." Get your free copy by clicking here.

Andrew Tonner holds no position in any of the companies mentioned in this article. The Motley Fool owns shares of Johnson & Johnson and Diageo. Motley Fool newsletter services have recommended H.J. Heinz, McDonald's, Diageo, and Johnson & Johnson. Motley Fool newsletter services have recommended creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (13) | Recommend This Article (61)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 18, 2011, at 5:16 PM, TMFOpie wrote:

    Well said, Andrew. Keeping an eye on payout ratios is wise. I recall a few studies that we pointed to in the Million Dollar Portfolio book that demonstrated high yields and low payout ratios are the best dividend stocks to invest in over time. You get cash and growth in one.

    Fool on,

    Andy

  • Report this Comment On May 18, 2011, at 6:02 PM, steveelcpo wrote:

    There are lots of caveats on these types of articles and the stocks they discuss. That said, the idea of due diligence and knowing what you're buying is certainly relevant. I have seen more than one article that makes an erroneous apples to oranges comparison of stocks such as JNJ with MLP's, royalty trusts, and reits. While I don't know much about HIMX, stocks such as NMM are capital intensive (operate drybulk carriers) and the EPS figure may not represent the actual cash flow. Depreciation may be fairly significant, and cash flow may support the dividend in excess of the reported EPS. REITS are required to pay out a high percentage of their earnings to retain their tax status (think it's 90%), so the assertion here that anything over 75% is noteworthy could potentially exclude investors from even considering some excellent, high yield REIT investments.

  • Report this Comment On May 18, 2011, at 6:06 PM, samedge2 wrote:

    Great read - thanks for sharing. In applying this to REITs, how would you recommend proceeding? I know they're required by law to payout 90% of their earnings to shareholders, but I've seen some that have ratios that are much higher than 90%.Would you use 90% as your rule of thumb on REITs?

    Example - I've been watching GOV for a few months and the dividend payout is 148%. Stable, stagnant business model (it involves the government, after all), but either they're very confident or very foolish to stretch themselves in a real estate market awash in inventory. Any thoughts?

  • Report this Comment On May 18, 2011, at 7:30 PM, dudleydodger wrote:

    This article must have been done in haste and shows shallow analysis. I have been - and no longer am - a stockholder in NMM for reasons discussed below and it is the distributable cash flow that covers the dividend not the EPS.

    I have no ax to grind here. I sold my shares of NMM because the frequent secondary distributions - up to 4x a year - would chop 5-10% off the stock price and were hard to time.

    But this article is irresponsible. Please have intelligent articles posted in the future.

  • Report this Comment On May 18, 2011, at 8:41 PM, HectorLemans wrote:

    The WD-40 company is another solid dividend payer. It's paid out a dividend the last 20 years and currently sports a yield of 2.65% and payout ratio just slightly over 50%

  • Report this Comment On May 19, 2011, at 10:37 AM, stelz wrote:

    I'm sure you're aware that dividends are only payable because of cash flow rather than earnings, which are muddied by accrual accounting. Take DHT - free cash flow is about 5x larger than earnings, nearly all because of non-cash depreciation.

  • Report this Comment On May 19, 2011, at 11:09 AM, TMFTheDude wrote:

    Thanks for all the feedback everyone!

    Regarding DHT, even when adding back depreciation, the company has a negative cash flow from operations after Cap Ex. It looks like DHT largely achieved its positive cash flow figure by issuing debt and common stock.

    Just like earnings, not all cash flow is created equal. Given the sources of its cash flow (financing not operations), the company's dividend still looks risky to me.

    Please share your thoughts!

  • Report this Comment On May 19, 2011, at 12:54 PM, stelz wrote:

    "Regarding DHT, even when adding back depreciation, the company has a negative cash flow from operations after Cap Ex. It looks like DHT largely achieved its positive cash flow figure by issuing debt and common stock."

    Guess if you look at Q1 2011 that's true. They bought a new ship after all, which requires a huge capital outlay. Look at the prior quarters and past couple of years, in which free cash flow was quite high.

    Just saying that it's not as simple as looking at a single stat and calling dividends "good" or "bad." Especially when using a short time horizon. In the case of DHT, you have to consider whether they can generate attractive long-term returns on these investments (i.e. ships) that they make. If they can, that dividend may be quite compelling.

  • Report this Comment On May 19, 2011, at 2:00 PM, mikecart1 wrote:

    Payout ratio is one of the only good indicators left. Just look at what happened to all the banks and WWE.

  • Report this Comment On May 19, 2011, at 7:22 PM, drborst wrote:

    Tell me if I'm completely wrong, but it seems to me that US stocks like to pay dividends at a constant (almost bond like) or increasing yield, sometimes no matter what earnings are, while foriegn stocks often pay out closer to a constant payout ratio, with variable yield.

    I mention it because looking at HIMX, you can see that they payout once per year and the amount has decreased from 0.35 to 0.30 to 0.25 over the past three years. I haven't looked at earnings, but I suspect they have a similar trend.

  • Report this Comment On May 25, 2011, at 3:23 PM, LQM2 wrote:

    I think the conclusion about DHT is dead wrong and the title of this article is irresponsible based on the shallow analysis. 1Q11 OCF of $11 covered dividend of $5. FY10 OCF of $34 covered dividend of $15. High capex in 1Q11 was because they bought a new ship to grow...the other ships are long-lived assets. In previous quarters they were paying down debt like crazy. GAAP payout ratio is practically useless in this industry.

  • Report this Comment On May 25, 2011, at 3:26 PM, LQM2 wrote:

    My apology to steltz above...you made the same point but I read it after the fact...anyway, I agree, DHT deserves a hard look with that 10% yield...can't use GAAP payout.

  • Report this Comment On July 09, 2011, at 1:15 AM, fallguy1000 wrote:

    This article is not entirely correct anymore as HIMX dropped their dividend from the cited $0.25 to $0.12. A forward look versus TTM look greatly changes the results of the article. HIMX also authorized a $25M share buyback. With shares out of about 175M and a $2 share price, the $25 million(if executed) will also reduce shares out by about 12M, let's call it 7%. That 7% is really an increase in EPS as well. So, ceteris parabis, a 7% increase would be roughly $0.16 EPS and the dividend of $0.12 would result in a payout ratio of 75% going forward versus the 171% you cite on TTM from March. A big caution for the readers is that the dividend payout isn't as cited anymore.

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