Dividend stocks represent the cornerstone of every well-constructed retirement portfolio. High-yielding stocks can help you recoup your original investment in a little over a decade -- which is a pretty amazing deal when you think about it.
But not all dividend stocks are created the same. All too often, a yield that seems too good to be true is, in fact, far too good to be true. That high yield is often the result of more serious problems that get to the core of an organization's business model.
Today, I'll examine three stocks yielding over 7%. But don't be fooled; I'd never buy any of these stocks.
Image source: Getty Images.
Two clothing retailers that have fallen on tough times
It doesn't take more than five minutes perusing the headlines to see that brick-and-mortar retailers are in trouble. Sears Holdings has finally apparently admitted that its days are numbered. Shopping malls are bare skeletons compared to what they were just a decade ago. And shareholders of these companies are suffering. Clothing retailers haven't escaped the trend.
But that doesn't mean they can't woo investors with big payouts. Guess (GES -2.00%) and Abercrombie & Fitch (ANF -3.86%) both have stocks that offer outsized dividends: 8.3% and 7.1%, respectively.
Dividends are paid out from free cash flow (FCF), and monitoring how much free cash flow is used for the payout is a good proxy for measuring the health of a dividend. Here's how both companies have stacked up over the past three years.
Data source: Company annual reports.
As you can see, both companies had relatively healthy dividends entering 2016. Guess used 80% of its FCF in 2015 on its dividend, while Abercrombie used a paltry 32%. But those trends reversed sharply in 2016 -- with Guess' FCF going negative, while Abercrombie was forced to pay out 122% of its FCF. That's not sustainable.
How did this happen? The overarching theme is simply that the comparable-store sales (comps) at these once-popular clothing retailers are suffering. Look at how the key metric has changed at both of these companies over the past few years.
Data source: SEC filings. Percentages rounded to the nearest whole number.
As you can see, people are simply spending less and less at these retailers. And it should be noted that for Guess, sales via its e-commerce line are included in comps.
Without a doubt, these companies will pursue a number of avenues to stay viable: closing underperforming stores, using cash on hand to buy back shares to prop up the stock, and focusing more on e-commerce.
Those strategies may help stem the tide over the short term, but over the long run, I simply don't believe that the outsized dividends being offered by these two are worth the risk of hoping for a reversal of fortune in the face of e-commerce's never-ending assault on brick-and-mortar retail.
Gaming has changed, and it isn't going back
The third company I'm calling out was once a hugely successful business: GameStop (GME 7.58%). The company was once the go-to place for gamers. But as gaming companies have pursued healthier business plans -- namely, online subscriptions for games that can be continuously upgraded -- the need for consoles or physical game cartridges has fallen by the wayside.
To be clear, the company's current yield of 7.3% is fairly healthy by traditional metrics: in the past three years, GameStop has never had to use more than half of its FCF to pay its dividend. That's very healthy!
But even though the company has done its best to diversify its offerings in the face of a switch to mobile and remote gaming, the long-term trends are finally starting to bear down on investors. Take a look at the comparable-store sales at GameStop and you'll see what I mean.
Data source: SEC filings. Percentages rounded to the nearest whole number.
That downtrend was underscored by a 21% drop in comps during the fourth quarter in America. While I applaud management's attempts at diversifying, I simply think there are too many forces working against this brick-and-mortar retailer to justify taking a flyer on the company's dividend.
At the end of the day, investors want companies that not only have healthy and substantial dividends, but business models that will still be around when they call upon their nest egg to provide for them in retirement. That's why I don't plan on buying shares of any of these three companies for my own portfolio.
