Early on in my investing life, I identified dividends as a key focus area. Unfortunately, I had a fair amount of success in buying stocks with ultra-high yields, with my starting point for considering a new investment at 10%. Time, and capital losses, taught me that a big dividend yield is nice, but it is not enough information on which to base an investment decision.
Here are a few examples of what I mean.
The BDC business model is leveraged
Back before the Great Recession, I owned a couple of business development companies (BDC). These BDCs provide loans to small- and mid-size companies, passing through much of the interest income they earn to shareholders in the form of dividends. When I bought into industry-leading names (at least at the time) like Allied Capital, they were paying 10%-plus dividend yields.
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And then a deep recession hit, and the leverage inherent in the BDC business model suddenly mattered a great deal. Dividends got cut, companies went out of business, and Allied Capital ended up selling itself on the cheap to another company.
I had owned my BDC investments for around a decade or so, and the dividends I collected offset the capital loss I experienced. It would be hard to describe this as a failure, but it certainly wasn't a success.
The big takeaway for me was that leverage is a business killer. And it tends to kill quickly. If you are looking at a stock with a high yield, make sure leverage isn't a risk.
A changing business can change the dividend
I never ended up buying clothing maker VF Corp. (VFC 0.16%), which worked out well for me because the high yield it offered when I started looking at it just didn't last. The big takeaway here is that VF reinvented its business, shifting away from its historical approach of having a reliable and boring core, layering on more growth-oriented businesses. The big change came when it spun off Kontoor Brands into own its basics business.
With that move, the foundation was stripped away. And the company's performance was fully tied to its fashion brands, including Vans and The North Face.
When it started to experience headwinds in some of its fashion brands, the company didn't have the income from its basics business to fall back on to support the dividend. And thus, a dividend cut. I feared exactly that outcome and stayed away.
This is a lesson to be applied to other dividend-paying companies as they strip away core businesses to focus more on growth.
Turnarounds don't always work out as planned
Foot Locker (FL 0.23%) is another cautionary tale. I managed to avoid the lesson by not buying it despite the high yield that attracted me to the stock.
This particular retailer rebounded strongly from the pandemic downturn, but then sales quickly started to peter out. Management acted quickly, putting a turnaround plan in place.
The problem is that the retail environment the company faced continued to get worse and worse. Guidance was weak at the start of 2023 and was further reduced in the first and second quarters. The company's turnaround plan took precedence over the dividend, which makes sense.
But what really sealed the deal was the fact that management wasn't capable of living up to its own expectations. The company has positioned the dividend as being on pause, which suggests it will come back at some point. But if management can't execute better, the dividend could be gone for a long time.
Buying stocks when they are out of favor is often a great time to find high yields. But you need to make sure the opportunity for a business turnaround is strong and track company performance closely to make sure the expected progress is being made. Otherwise, you might end up shocked by a sudden dividend "pause."
Some dividends aren't meant to last
Pioneer Natural Resources (PXD -2.28%) operates in the highly cyclical energy sector. As a producer of oil and natural gas, the company's top and bottom lines can vary dramatically from year to year and even quarter to quarter.
What's notable here is that Pioneer tied its dividend to its financial performance. That has the effect of leading to a rising dividend when energy prices are going up and a falling dividend when energy prices are heading lower. The dividend has been in decline for the past year, tracking along with oil prices.
When the dividend was rising, Pioneer's yield jumped into the double digits. But it wasn't sustainable and was never intended to be. There are other companies that use similar variable-dividend policies. Simply put, you need to understand the policy backing a huge yield or you could end up finding out that the yield isn't the important variable.
Don't get burned by dividends
I can't help myself: When I see a double-digit yield, I look. I sometimes even get a little flutter, thinking that I've found a rare diamond in the rough.
Luckily, time and some painful lessons have taught me that most often, a big yield is a warning sign of risk and not an opportunity. Now I do more digging and, older than I once was with far more responsibility to shoulder, I tend to err on the side of caution more often than not.
For most investors, that's a far better approach, with the above examples highlighting just some of the problems that you can get into if you focus first and foremost on dividend yield.
