Investing in high dividend-yielding stocks has always been attractive. We know that share prices and dividend yields move in opposition to each other. So, in case a stock price has fallen by 20%, its forward yield will rise by the same number. This means a dividend stock that has lost significant momentum in recent times will not only have a tasty yield, but also may provide investors with an opportunity to increase returns via capital appreciation.
In the current economic situation where interest rates are at record lows, dividend-paying stocks seem like a winning bet. But investors need to consider several other factors while allocating capital to such investments.
1. High dividend-yielding stocks generally have low share price appreciation
Dividend stocks are likely to generate a stable stream of passive income. A dividend-paying company is generally a safe option. But on the flip side, one reason that companies pay dividends to shareholders is due to excess cash reserves. These companies, with some exceptions, have exited the growth stage and depend on steady cash flows to reward investors.
In the technology sector, several dividend-paying stocks, such as AT&T, Verizon, and IBM, have eye-catching forward yields of 6.8%, 4.3%, and 5.3% respectively. However, all these companies have experienced low single-digit organic business growth in the last few years, and their stock prices have unsurprisingly remained range-bound. In the last five years, shares of AT&T, Verizon, and IBM have returned -5.5%, 17.5%, and -24.4% respectively.
While these may be cherrypicked examples, scenarios like this are commonplace.
Investors ideally need to find companies that have the potential of solid long-term revenue growth and pay a decent dividend to maximize returns.
2. Dividend payments are not a guarantee
Unlike interest, dividend payments are not a guarantee. In case of a recession or an economic downturn (as we are currently experiencing), investors not only see their portfolio values plunge, but might also be subjected to lower dividend payments. Companies with less-than-impressive fundamentals may announce a dividend cut or stop payments altogether.
Last year, we saw tech giant Nokia announced it would stop dividend payments as it has to invest heavily in 5G infrastructure. The networking giant is part of a mature business, and its low profitability coupled with high capital expenditure led to the dividend withdrawal. Nokia last announced a quarterly dividend of $0.045 per share on July 29, which indicated a forward yield of close to 4%.
Currently, several energy stocks have high yields, as stock prices have been decimated due to the massive slump in oil prices. Oil companies such as EnLink Midstream and Vermilion Energy have announced dividend cuts, and several others may soon follow suit.
3. Payout ratio is important
One of the most important metrics that needs to be looked at while investing in dividend stocks is the payout ratio. This ratio can be used to measure a company's ability to keep paying dividends.
A lower payout ratio suggests that a company has enough room to increase dividend payments in the future or keep paying them even in an economic recession. As a rule, a payout ratio of over 70% should make investors wary.
As usual, there are exceptions here, especially among companies in the utility and real estate segments. Due to a steady stream of cash inflows, utility giants are able to sustain high payout ratios, while real estate investment trusts have to pay over 90% of earnings in dividends.
Dividends depend more on cash flow than earnings. For capital-intensive companies like utilities, net earnings will be affected by non-cash items such as depreciation, while cash flow will remain stable.
Currently, high dividend-paying energy stocks may have to cut dividends due to lower-than-expected cash flows that will be affected by lower oil prices and tepid demand. Unless they have enough cash reserves and low debt, a high payout ratio is unsustainable over the long term for most companies.
4. Look at the business model
When it comes to paying dividends, companies need to depend on solid business models that will result in strong balance sheets. Broadcom is a leading smartphone chip supplier, an industry that has grown at a staggering pace over the last decade. This has helped the semiconductor giant increase dividends by a stunning 4,500% since 2010.
Currently, Canadian pipeline giant Enbridge, which has a forward yield of 8.5%, is one of the safest bets in the energy sector despite rock-bottom crude prices due to its robust business model. Enbridge generates 98% of cash flows from fee-based contracts and similar agreements, making it almost immune to commodity price changes.
Likewise, although Apple generates over 60% of sales from iPhones, its services business will help offset cyclicality in the coming decade. Apple now has several subscription businesses such as Apple Music, iCloud, Apple Arcade, and Apple TV+. These revenue streams should balance low smartphone sales in these uncertain times, helping the technology giant to maintain cash flows.
5. Avoid the dividend yield trap
High dividend yields are attractive if the company continues to grow dividends over the years. Companies such as Broadcom and Apple have continued to increase dividends per share in the last decade.
However, currently, the yields of several companies have sky-rocketed due to a volatile global environment. The current pullback in stock prices has increased yields higher, and this is known as the dividend yield trap. For example, Suncor Energy has a high yield of 8.5%. However, the stock has lost over 60% in market value since July 2018, wiping out significant investor wealth.
Investors should not look at high dividend yield stocks in isolation. They also need to consider the company's future growth metrics, its payout ratio, and other fundamentals mentioned here before making an investment decision.