I suspect it would be hard for dividend investors not to salivate at the potential offered by British American Tobacco's (BTI -0.54%) 9.5% dividend yield. But dividend investors also know that yields that high usually come with material risks, which is exactly the case here.
If you are looking for a reliable dividend stock with a high (though not quite this high) yield, you might be better off switching gears and examining Realty Income (O -0.60%) and its roughly 6% yield. Here's why.
I don't like British American Tobacco's business
British American Tobacco has a massive dividend yield, and it's a dividend that is likely to hold up over the near term. But I invest in stocks with the idea that I'll own them for decades. Given that mindset, I prefer to buy companies that I think have long-term growth potential. Right now, British American Tobacco does not.
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The company's core product is cigarettes. Smoking cigarettes has been falling out of favor for years, leading the company's cigarette volume to decline by roughly 21% over the past five years or so. It should trouble any long-term investors that a consumer staples company witnessed that kind of decline in its most important business.
Management is working to build up new business segments to compensate, but right now the only way to deal with the declining cigarette business is to raise prices. That's not a long-term solution, and only the most aggressive investors should even consider British American Tobacco until the company's transition away from cigarettes starts to gain more traction.
Boring Realty Income is a better dividend stock
A better option for dividend investors would be Realty Income, the largest net lease real estate investment trust (REIT). Net leases require tenants to pay most property-level operating expenses. The REIT offers a very attractive dividend yield of nearly 6%, backed by a dividend that has been increased for a huge 30 years and counting. What you lose in yield relative to British American Tobacco, you make up for in the quality of the underlying business.
For example, Realty Income, with a market cap of $45 billion, is over three times larger than its next closest competitor. The REIT's balance sheet is investment grade rated, and it has a portfolio that spans across North America and, increasingly, Europe.
There are a number of positive takeaways here. First, Realty Income's size and financial strength allow it advantaged access to capital markets. So it can afford to bid aggressively on acquisitions and still make a profit. Second, its size allows it to take on deals that smaller peers couldn't even consider. That includes simply buying other REITs as Realty Income consolidates the industry. Third, with exposure to Europe, Realty Income is helping to develop a large market that is only just beginning to use the net lease model. Thus, it has multiple levers for growth versus domestic-focused peers.
But the real takeaway from the comparison between Realty Income and British American Tobacco is that the REIT is building from a position of strength. The cigarette company is just trying to find a new business to be in, bleeding its cash cow for the money it needs to support its oversized dividend and capital investment needs. If you are hoping to live off your dividends for decades, Realty Income should sound like an easy winner in this match-up.
Dial down the risk -- a 6% yield is still pretty darn good
The S&P 500 index is offering a scant 1.3% dividend yield. You can reach for yield by taking on huge risks via an investment like British American Tobacco. If you do, you'll need to watch the company's fading cigarette business like a hawk and pray it can find a way to offset the ongoing decay. Or you can just buy a good company with a growing business like Realty Income that has a still generous, but totally supportable, yield of 6%. The risk/reward balance makes Realty Income the easy choice for me.
