We all know about investors' current preoccupation with dividend stocks. This, of course, is quite justified compared with other alternatives (like bonds or cash, which promise essentially no return). Stocks that actively pay their owners provide a pretty attractive option in today's low-yield environment.
However, investors need to look past the hype and realize that, although lovely in many ways, these investments do carry certain risks, some much greater than others. Today I'll detail one specific dividend investment that certainly alarms me.
The dividend universe is a diverse place. Opportunities run the gamut from stable companies that pay dividends like clockwork, such as Johnson & Johnson (NYSE: JNJ ) and Intel (NYSE: INTC ) , to companies with payouts well into the double digits. The stocks I have in mind exist on the higher-yielding end of the spectrum.
Even in assessing high yield stocks, it's important to avoid equating all companies as dangerous as the next stock. REITs, or real estate investment trusts, serve as a fair example of an industry known for its dividend prowess. Home to dividend powerhouses Annaly Capital Management and Chimera Investment that yield 14.8% and 19.5%, respectively, these companies couldn't be more different from J&J and Intel. Their dividend policies have certain characteristics you might not find elsewhere in the investment world. You see, REITs are a special corporate structure (formed as an investment fund) that receives unique tax benefits on its income so long as it pays out a high percentage of its income every year. The point here is that sometimes large payouts occur for good reason.
Sizing 'em up
The telecom industry also makes for about as fertile a hunting ground for exorbitant dividends as you'll find. The average company that pays a dividend in the sector -- not all do -- yields a robust 7.1%. Contrast that against the 2% yield of the S&P 500 (INDEX: ^GSPC ) and 2.9% of the Dow Jones Industrial Average (INDEX: ^DJI ) and you get the picture. Telecom stocks often take returning cold, hard cash to their shareholders quite seriously.
On the riskier end of the spectrum, payout behemoth Alaska Communications Systems (Nasdaq: ALSK ) should send investors running. Its siren song, a 16.1% dividend yield, could blow up in your face, making it exactly the kind of dividends investors should avoid. On the surface, the company appears a model of consistency. It's paid dividends out like clockwork since 2004 (the company was only founded in 1998), despite reporting losses sporadically throughout the period. Losses appearing intermittently should probably raise a red flag for most investors.
However, investors interested in investing in telecom stocks will fare better if they frame their analysis around cash flow versus reported income, even more so than investors in other sectors (one of those industry norms again). Telecom firms are renowned cash cows, much more so than merely looking at their income statements might indicate. Since surviving in the industry requires heavy capital investment, telecom companies often have extremely high depreciation costs that erode substantial portions of their recorded profits.
As a result, using tools like the earnings payout ratio fail to really accurately capture a telecom company's ability to make payments to its shareholders. However, turning to the cash flow statement will give investors a much better sense of the relative health of companies in this industry. You can see this distinctly in rural telecom Frontier (NYSE: FTR ) as well.
In Alaska's case, it generates much more consistent, albeit not wholly unblemished, cash flow that it uses to pay shareholders. Over the last 12 months, Alaska generated $27 million in free cash flow versus a net income loss of $3.1 million during the same period. And while that seems great, Alaska's cash dividend payments still comfortably outstripped its cash flow over the period, to the tune of $38.6 million in dividend payments, well above the $27.6 million in cash that came in the door.
The company's most recent conference left shareholders even more rattled. Although management couldn't specifically comment on the dividend going forward (the board of directors sets such policies), it did reveal several key points that paint an ugly picture for the future. First, CEO Anand Vadapalli admitted to investors during the call that "our board has been reviewing our dividend policy ... we expect this matter will receive additional scrutiny." The stock dropped 28% in reaction to this ominous news about the safety of the firm's beloved payout.
Worse yet, the firm sees mounting competition on the horizon. Telecom heavyweight Verizon Wireless (NYSE: VZ ) announced this year that it intends on entering the Alaskan market. The telecom notoriously favors the big fish that have the resources to make key investments and offer popular phones at attractive prices. Verizon will clearly loom large as it challenges Alaska for share of this remote market. Put all this together and Alaska, and its prodigious payout, looks poised for a rough patch.
Foolish bottom line
As I hope you learned here today, investors need to approach dividend investing with a healthy dose of skepticism. Although a great way to help drive a portfolio's overall returns, these payouts also carry their own set of risks investors need to fully understand before investing. Unfortunately, a higher yield doesn't necessarily guarantee a happier portfolio. In the end, investors need to fully understand the sector norms and the individual circumstances surrounding each company in which they invest. As I said above, buyer beware.
And if you want more ideas on other dividend opportunities, The Motley Fool recently compiled a research report detailing 11 Rock-Solid Dividend Stocks. Best of all, it's absolutely free for our readers. I invite you to pick up your free copy today.