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Why You Shouldn't Rely on These Dividend Stocks

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Investors are facing one of the toughest challenges they've ever had to deal with. With interest rates at rock-bottom levels, it's really hard to generate the income that many people need in order to make ends meet.

As a solution, many investors have decided to embrace dividend-paying stocks in lieu of bonds and other fixed-income investments. In a booming stock market, that's been a winning bet. But in the process, retirees and other conservative investors are adding to their risk levels -- and eventually, those bets could come crashing down on them, creating what could become a new financial crisis.

In search of cash
In this month's brand new issue of the Fool's Rule Your Retirement newsletter, which is available today at 4 p.m. EDT, Foolish retirement expert and financial planner Robert Brokamp takes a closer look at how investors are piling into dividend stocks. Not only are interest rates on bonds unattractive, but investors are also concerned about the potential for capital losses even on ultra-safe Treasury bonds, as rising interest rates in the future could take a bite out of bond values.

My colleague John Rosevear argues that dividend stocks are simply the best way to get the income you need. But before you accept his argument, let's take a look at how investing in dividend stocks can go horribly wrong -- and end up putting you in an even worse financial situation.

Dividends aren't forever
Investors need steady, reliable income in order to plan their finances. The benefit of bonds is that no matter how much or how little they pay, you know in advance exactly how much you're going to receive and when you're going to get it. Barring a cataclysmic event like a default, a bond's payouts are reliable and dependable.

By contrast, dividends from stocks are inherently unpredictable. Although that lack of predictability sometimes results in positive surprises when dividends increase, companies have no legal obligation to keep paying dividends at all, leaving the door open to dividend cuts at any time.

That's a lesson that all too many investors learned the hard way three years ago. Back then, dividend stalwarts General Electric (NYSE: GE  ) and Dow Chemical (NYSE: DOW  ) made big dividend cuts of 60% to 70%. Accompanied by the huge share-price drops during that period, shareholders who relied on what had previously been attractive dividend yields got a nasty reminder of how risky stocks are.

Moreover, we're still seeing similar moves today. Take a look at what's happened to some of these favorite dividend stocks:

  • Frontier Communications (Nasdaq: FTR  ) has been a cash cow for shareholders over the years, as it pays out the lucrative cash flows from legacy wireline telephone service revenue. But on two occasions during the past 18 months, the company has had to cut its dividend, which now stands 60% below where it was in mid-2010. The current yield of 9% may still look attractive, but with shares having lost half their value in less than a year's time, longtime investors certainly haven't gotten the results they'd hoped for.
  • Another area that income-hungry investors have looked to is the mortgage REIT sector. These companies make money on the spreads between short- and long-term interest rates and pass their profits through to shareholders, and the double-digit yields they offer are exactly what many people need right now. But Annaly Capital (NYSE: NLY  ) already pays less than three-quarters of what it did in late 2009, and further pressure on rates could prompt future cuts. Compared to current levels of $0.55 per share in quarterly dividends, Annaly paid only $0.10 in late 2005. Chimera Investment (NYSE: CIM  ) has seen even faster dividend deterioration, with a nearly 40% cut since late 2010. Moreover, both stocks trade at levels well below their highs of the past couple of years.

Of course, plenty of dividend stocks not only maintain payouts but raise them regularly. Yet even in those cases, a stock market swoon can create losses that conservative investors can't afford to weather.

Best of a bad lot
So if you need income, how much can you afford to rely on dividend stocks? The new issue of Rule Your Retirement gives a balanced view of both bonds and dividend stocks, helping you figure out the right mix for your portfolio. And it's available free with a 30-day trial subscription.

Even with low rates, bonds do something that dividend stocks can't: hold their value and assure repayment of principal. For most investors, that's a feature that you just can't live without.

Getting the income you need is just one element of a successful financial plan for your retirement. Our special free report highlights the shocking truth about your retirement. Don't miss this chance to grab your free copy of this can't-miss report today.

Fool contributor Dan Caplinger deals with the ups and downs of dividend stocks. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. 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 Fool's disclosure policy never loses value.

Read/Post Comments (8) | Recommend This Article (14)

Comments from our Foolish Readers

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 April 05, 2012, at 11:53 PM, TnFlash2u wrote:

    Even with though Annaly's dividend has dropped, it still is on track to pay nearly 14%. If it drops to half of that, 7% is still double what some companies that are considered choice dividend companies pay. Plus Annaly is trading near a two year low and the Fed has stated predicted interest rates will remain low until 2014 which ensures a good spread margin for the company.

  • Report this Comment On April 06, 2012, at 3:26 PM, frank3773 wrote:

    Dan -

    With all the supposed concern about dividend sustainability why no mention of "return of capital" which comprised over 77% of 2011 dividends. ROC is a return of your own money, not a real dividend, and it lowers your cost basis, dollar for dollar, so when you sell, you have a supposed capital gain to pay tax on.

    Frontier's real dividend for 2011 was only 16 cents per share, not the $.75 that's touted everywhere. (40 cents for 2012). The 10% yield on FTR is really 2.2%. In the past 4 years a significanat part of distributions has been ROC, and for this year (2012) we won't know until after the end of the year.

    Since I discovered this phenomena and how it works, I've thrown this question out multiple times: How is ROC and advantageous investing strategy for us investors? So far no one seems concerned - is there a source of info I could go to??

  • Report this Comment On April 06, 2012, at 3:31 PM, frank3773 wrote:

    Oops -- forgot to mention in first sentence - the 77% refers just to Frontier. I have 2 other stocks that also included return of capital in their distributions, but which, as mentioned, we can't know until end of year (reported on 1099.)


  • Report this Comment On April 06, 2012, at 6:12 PM, racchole wrote:

    Interest rates won't stay where they are through 2014. I'd be wary of relying on Fed statements. Capital depreciation in value of NLY can easily erase a large chunk of the "14%", and can seriously endanger your money if they cut the yield to 7%.

  • Report this Comment On April 06, 2012, at 9:05 PM, Buffettinvestor wrote:


    You're making the perfect case for contrarian (David Dreman) and Value plays for all these five companies.

    As you say, all companies are way off their all time high, and have thus had to cut their dividends, but the dividend yields at these price levels are still not that bad.

    Except for FTR and NLY, all companies have reasonable p/e ratios as well. Three of them have p/b below 1 (two of them including tangible book value), and the other two around 1.5 and just over 2, which isn't that expensive either. Most also have excellent p/s ratios under 1.

    All these basic valuation ratios have been proven to beat the overall stock market long term (Graham & Dodd and Tweedy, Brown).

    One of the reason for that is that management is not going to sit around and be content with these declining earnings.

    Management is going to do everything they can to get their earnings back to where it used to be, or they'll be replaced by management that will!

    Sure, both the price and the dividends might drop from here, which is why one should spread out the investments over time (dollar cost averaging).

    A wise man once said "Be fearful when others are greedy, and greedy when others are fearful."

    To me, it seems like this article is arguing AGAINST this profound wisdom, and that these companies meet several criteria for good value investing. Most seem to be selling under their intrinsic value based on these three valuation criteria

    Doing a discounted free cash flow analysis would be extremely difficult in my view, as it, for me at least, would be extremely hard to estimate when and buy how much these companies would start to grow again. I therefore only used the main value analysis rations, since the same wise man also said, paraphrasing Keynes "I'd rather be vaguely right than precisely wrong."

    I really don't get the point you're trying to make... It would be very interesting to see what these companies' ROIC are and have been for the last 10 years (as well as what it will be when they turn around), but I have not found a place where I can find this ratio, and they are not that cheap for me to be motivated to calculate it manually.

  • Report this Comment On April 08, 2012, at 12:06 PM, TMFGalagan wrote:

    @frank3773 -

    It's a reasonable point, but one that doesn't apply to a large group of dividend-paying stocks. It certainly *does* apply to many closed-end funds, whose high yields mask huge premiums to net asset value and unsustainable payouts based largely on returning shareholders' money back to them.


    dan (TMF Galagan)

  • Report this Comment On April 08, 2012, at 12:08 PM, TMFGalagan wrote:

    @Buffettinvestor -

    Sure, *now* you could argue that these stocks are value plays precisely *because* disappointed dividend investors have taken them out to the woodshed. With the focus of my article being people investing primarily for dividends, the stocks were a cautionary tale about what can happen when dividends go bad. In the long run, these stocks might be okay, but I think they'll be a disappointment to those who bought them solely for their dividend payouts.


    dan (TMF Galagan)

  • Report this Comment On April 08, 2012, at 10:44 PM, Buffettinvestor wrote:

    Got it. Thanks!

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