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The 2 Most Dangerous Types of Dividend Stocks

By Sean Williams - Mar 30, 2017 at 9:29AM

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High-yielding stocks with struggling business and debt-funded payouts are often bad news for income investors.

More often than not, dividend stocks are what form the foundation of the best retirement portfolios. It's not hard to understand why, either. Over the long run, dividend-paying stocks have run circles around non-dividend paying stocks in terms of overall return.

Dividend stocks are often portfolio saviors

The first reason investors often seek dividend stocks is that a regular stipend serves as a beacon of assumed profitability and sustainability. In other words, in a perfect world no company is going to continue to share a percentage of its profits with investors if it doesn't believe it'll remain healthfully profitable and continue to grow.

A young girl fanning a pile of cash.

Image source: Getty Images.

Dividend stocks are also quite helpful in hedging against the inevitable downside in the stock market. Since 1950, according to data from Yardeni Research, there have been 35 stock market corrections in the S&P 500 of at least 10%, when rounded to the nearest whole number. While most dividend payments aren't going to completely cancel out this often short-term move lower in stock valuations, it does help ease investor worries in the short term.

Finally, and arguably most importantly, dividend income can be reinvested back into more shares of stock via a dividend reinvestment plan, or DRIP. DRIPs are what top money managers use to generate significant wealth for their clients over the long run.

But dividends can have a dark side, too

However, dividends can also be deceptively dangerous if you aren't careful. If you don't take the time to understand the health of the business behind a dividend, or fully understand how a dividend is being funded, it could come back to haunt you.

Here are two of what I'd consider to be the most dangerous types of dividend stocks.

1. High-yield dividends with ailing businesses

Arguably the most dangerous type of dividend stock is a high-yielding company (think 4%-plus yield) with a struggling business. Keep in mind that a dividend yield is nothing more than a company's annual payout as a function of its share price. If a company's share price has fallen 50% in a year, its dividend yield will have doubled. If you haven't taken the time to study how healthy the underlying business model is for a high-yield dividend stock, then you could be setting yourself up for trouble.

A frustrated stock broker holding his hands on his head.

Image source: Getty Images.

For example, telecommunications service provider Frontier Communications ( FTR ) currently has a dividend yield of 20% following the release of its less-then-stellar fourth-quarter results. Over the trailing 12-month period, Frontier's share price has fallen by 65%, which has more than doubled its dividend yield. If this yield were sustainable, investors could double their money in less than four years. However, if it looks too good to be true, it often is.

Frontier is actually dealing with a number of issues that have no easy fix. The company believed that buying high-margin wireline assets from Verizon on a handful of occasions would allow it to generate significant cash flow. While that has partly been true, management apparently didn't do a great job of accounting for the rise of wireless mobile devices, which have made landlines somewhat obsolete. As a result, Frontier has been dealing with a steady loss of landline customers for years, which is eventually going to whittle away its cash flow and force what's likely to be another dividend cut. Broadband gains have also regularly disappointed Wall Street.

The primary reason investors are buying Frontier's stock is its lucrative dividend, meaning more pain could be in store for shareholders if and when Frontier's payout is once again cut.

2. Debt-financed payouts

It's no secret that a company paying a generous dividend will attract long-term income investors who's ownership tends to lessen volatility in a company's share price. However, when a company gets so desperate to reward shareholders that it issues debt in order to pay a dividend, there's reason to worry.

A street sign labeled "risk ahead."

Image source: Getty Images.

Back in April 2014, Innoviva ( INVA -0.67% ), which was then known as Theravance and was planning to split into two separate companies, Innoviva and Theravance Biopharma, completed the private placement of $450 million in debt at a 9% rate. The reason for the offering from Innoviva was to "support the initiation of a capital return strategy to the stockholders of Theravance, Inc. in conjunction with the previously announced spin-off of Theravance Biopharma." In other words, the debt was to pay a $0.25-per-quarter dividend to shareholders.

On paper, the company's decision to offer a dividend looked smart. Innoviva was the development partner that aided GlaxoSmithKline ( GSK -0.53% ) in developing its cadre of next-generation long-lasting COPD and asthma medications, including Breo Ellipta and Anoro Ellipta. If these therapies achieved their blockbuster sales expectations, Innoviva should be rolling in the dough as a royalties company with little overhead expenses.

Here was the problem: Breo, Anoro, and the remainder of GlaxoSmithKline's and Innoviva's COPD and asthma drugs struggled out of the gate. Many have since improved, but it's been a challenge to bring to physicians' and consumers' attention that a new long-lasting COPD and asthma treatment option exists. The result is that Innoviva had, until recently, been losing money -- so much so that the company suspended its $0.25-per-quarter dividend after just five quarters in 2015.

Though the company is profitable now, it's left with $478.5 million in non-recourse notes as of Dec. 31, 2016. All in all, issuing debt to fund a short-lived dividend was a terrible idea in hindsight.

Income stocks can be a real asset to your portfolio, but you'll need to do some digging to ensure that a company's payout is sustainable. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Frontier Communications Corporation Stock Quote
Frontier Communications Corporation
FTR
Innoviva, Inc. Stock Quote
Innoviva, Inc.
INVA
$16.36 (-0.67%) $0.11
GlaxoSmithKline plc Stock Quote
GlaxoSmithKline plc
GSK
$41.25 (-0.53%) $0.22

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