The first rule of income investing is to never chase a high yield. In many cases, an abnormally high yield indicates that a company's business is stagnant, or previous problems knocked down its share price and inflated its yield.Free cash flows also might not be enough to cover a company's dividend -- which means that big dividend cuts could be on the way.
Let's take a look at three stocks with deceptively high dividends which investors should ignore.
Nokia (NYSE:NOK) initially looks like a good dividend play. Its core business of telecom equipment has a wide moat, its consumer brand is being reborn with low-risk licensing deals, and its trailing yield of 3% looks attractive relative to the S&P 500's average yield of 2%.
But if you dig deeper, you'll notice that Nokia spent $1.68 billion on dividends over the past 12 months, but had a negative free cash flow of $963 million during that period -- mostly due to its $16.6 billion takeover of rival Alcatel-Lucent last January. Nokia's forward yield also remains uncertain, because it announces its dividend every year at its annual meeting (the next one will occur on May 23).
Nokia hasn't delivered reliable dividend hikes in the past. It suspended its dividend in 2013, but paid out a dividend of €0.37 per share in 2014 after Microsoft's purchase of its handset division juiced up its cash flows. That payout fell to €0.14 in 2015, but was lifted to €0.26 (with the inclusion of a special dividend) last year. But looking ahead, analysts expect Nokia's earnings to dip 4% this year as revenue drops 5% -- which indicates that a dividend cut could be in the cards.
Vector Group (NYSE:VGR) is a hybrid real estate and tobacco company that pays a forward dividend yield of 7.2%. In addition to that cash payment, it's paid out an annual 5% stock dividend since 1999. This means that Vector "gifts" investors with new shares based on their current position each year. For example, an investor with 1,000 shares at the end of the year will receive a 7% cash dividend in quarterly installments and 50 new shares at the end of the year.
Those numbers sound very shareholder friendly, and even more stunning when we notice that Vector's shares have rallied more than 50% over the past five years. But as I mentioned in a previous article, Vector's bizarre business model is actually based on funding dividends with debt as it repeatedly inflates its share count with stock dividends. That caused both figures -- which should ideally decrease -- to skyrocket over the past decade:
I think Vector hasn't crashed because its investors are staying invested to continuously collect the cash and stock dividends. But that party simply can't last forever -- Vector generated $126 million in free cash flow over the past 12 months, but spent $193 million on dividends.
The decline of the retail apparel industry -- which was caused by the rise of fast fashion retailers like H&M, declining mall traffic, fickle consumer tastes, and the growth of online superstores -- turned many apparel retailers into "accidental" high-yielders.
Guess (NYSE:GES), for example, saw its trailing yield surge from less than 1% ten years ago to nearly 8% today -- buy mostly because the stock lost nearly 70% of its value during that period. Despite that decline, Guess CEO Victor Herrero expressed his confidence in the company's dividend before, claiming that he had "reinvested 100%" of his dividends back into buying more stock.
Unfortunately, I don't think it's wise to follow Herrero's lead. Guess finally posted two straight quarters of year-over-year sales growth recently, but comparisons were fairly easy due to a multi-year streak of top line declines. Analysts expect Guess' revenue to rise 2% this year, but its earnings are still expected to fall 23% on markdowns. That bottom line deterioration is a bright red flag for its dividend -- Guess generated a negative free cash flow of $19 million over the past 12 months, yet spent $76.5 million on dividend payments. This means that its dividend -- which hasn't been raised since 2014 -- could be cut in the near future.
Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Guess?. The Motley Fool has a disclosure policy.