For most retirees and pre-retirees, dividends are the heart and soul of their investment portfolios and retirement accounts. Not only do dividends provide steady income on top of any share price appreciation, but they also signal to investors that a company has a business that can stand the test of time. Further, a company's payout serves as a downside buffer in case of market volatility or downside.
With this in mind, it's common for income investors to seek out companies whose dividend payments are on the rise. It's a smart strategy, because the stock market has averaged returns of almost 10% per year throughout history, and if a company's dividend remains stagnant while the share price rises, its yield will fall over time.
However, not all rising dividends are necessarily worth investors' hard-earned money. While most dividend increases are a genuine reflection of improving business quality, there are two scenarios in which dividend increases (and, to be clear, I mean an increase in the actual payout, not an increase in the yield resulting from a drop in the share price) should be looked at with sincere skepticism.
Scenario No. 1: Debt-driven dividend increases
Income investors may turn up their noses at companies that only pay out a small fraction of their earnings as dividends. However, what's worse is when a company offers debt in order to initiate a dividend or boost its current payout.
Take biopharmaceutical company Theravance (NASDAQ:THRX) as a good example. In April of last year Theravance closed a $450 million debt offering that yielded $434.3 million after fees. Among other purposes, this debt went toward paying partner GlaxoSmithKline certain launch milestones for a joint venture in chronic obstructive pulmonary disorder (COPD) treatments, as well as covering the $0.25 per-quarter dividend that the company initiated shortly after Theravance's COPD therapies, Breo Ellipta and Anoro Ellipta, were approved by the Food and Drug Administration.
But here's the problem: The launch of Breo Ellipta and Anoro Ellipta has been slower than molasses in January. In all fairness, Anoro was just approved last year, but since its May 2013 approval, Breo has fallen far short of Wall Street's blockbuster expectations. And let's not forget that Theravance only receives a small percentage of total sales, with the bulk going to partner GlaxoSmithKline. All told, Theravance's current yield of 8.1% might look juicy, but there's no genuine cash flow at the moment to back up $115 million in cash dividend outflows per year.
Companies that dip into debt in order to pay their shareholders a dividend should generally be avoided for dividend-income purposes.
Scenario No. 2: Divestment-related dividend increases
The second scenario isn't often thought of as worrisome for income seekers, but I'd suggest otherwise.
It's not uncommon for companies that are selling off assets (e.g., stock holdings from another company or a noncore business segment) to share some of the proceeds of a sale with shareholders.
Dow Chemical (NYSE:DOW), one of the largest chemical producers in the world, announced in 2014 that it planned to boost its share buyback program and its dividend in the wake of aggressive asset sales. In fact, Dow boosted its prior guidance for asset sales to a range of $7 billion-$8.5 billion from prior guidance of $4.5 billion-$6.5 billion. However, this type of dividend increase can be downright dangerous for income investors.
First of all, increasing a dividend following a divestment may not be sustainable over the long term. Once excess cash from the sale of an asset has been exhausted, then what? If the dividend is subsequently lowered, that could crush the company's share price, especially if income investors have come to rely on a certain level of payout.
The other concern is that a dividend increase following an asset sale might imply that a company doesn't have anything better to do with its money. Don't get me wrong -- I'm all for payouts for shareholders. But a majority of asset sales are undertaken because at least one aspect of a business is underperforming. Instead of simply handing the proceeds of a sale right back to shareholders, perhaps businesses would be better off looking for ways to put that capital to good use within its remaining business segments.
My suggestion to income seekers out there is to always be skeptical of these two scenarios. Neither is a definite sign of impending failure, but each has its own yellow and red flags that should cause investors to stop and think extra hard before trusting a company that will go into debt to pay a dividend or boost its dividend following the divestment of an asset.
Consider yourself warned!
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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