Though high-growth stocks may add some pep to your portfolios' step during bull markets, dividend paying stocks are often the cornerstone of successful portfolios.
Dividends provide a number of benefits that may not seem immediately obvious. For example, you probably think the benefit of a dividend lies solely in the check or deposit from a company whose shares you own. But there's more to it than that.
Three major benefits of dividend stocks
A dividend acts as a signal that a company's business model is strong enough to stand the test of time. If a company is willing to share a percentage of its profits with its investors, rather than reinvesting those dollars back into the business, then it seems management feels confident in its long-term prospects.
Additionally, dividends help guard against the stock markets' inevitable downturns, when cyclical growth stocks can really come back to bite aggressive investors. Dividend payments are a welcome buffer in a down market, easing the pain of lower equity prices. Dividend stocks also have a habit of instilling a long-term buy-and-hold mentality in their shareholders, helping to reduce share price volatility in many instances.
Dividend paying stocks also offer stakeholders the opportunity to reinvest their dividends back into more shares of the company, supercharging their returns over the long run. Dividend reinvestment is often what separate a good retirement portfolio from a great one.
The dangers of yield chasing
Unfortunately, dividend stocks can tempt investors to start chasing high yield.
In theory, the higher the yield, the more the investor will make. But investors often forget to ask whether or not a dividend is sustainable over the long run. In some instances it isn't, and an investor can find their dividend and the price of their shares under pressure.
The easiest way to determine the health of a dividend, beyond evaluating the fundamental model of a business (which you should do anyway), is to look at its dividend payout ratio. The dividend payout ratio is the percentage of annual net income that a company pays out to shareholders. As an example, a company that pays a $1 per-share annual dividend and earned $2.50 in EPS would have a dividend payout ratio of 40%.
Speaking arbitrarily, I look for dividend paying stocks with a dividend payout ratio between 50% and 75%. This implies that the management team pays a substantial amount of profits back to investors while leaving room for future dividend growth. As you might have correctly surmised, any dividend payout ratio above 100% -- or even above 90%, depending on the business model of the company -- could be unsustainable.
With this in mind, let's take a brief look at three stocks whose dividend payout ratios may be unsustainable.
1. PDL BioPharma (NASDAQ:PDLI)
Perhaps no company offers a better example of an unsustainable dividend payout ratio than PDL BioPharma.
Unlike a traditional biotech stock that develops drugs and ushers them through the clinical trial process, PDL BioPharma buys royalty interests and collects the revenue from the sale of drugs that utilize these interests. For years PDL's claim to fame has been its Queen patent portfolio, which allows it to reap royalty rewards anytime blockbuster drugs such as Herceptin, Avastin, or Lucentis are sold. Unfortunately for PDL BioPharma, its Queen patents expired in December, and its 9% yield is in serious danger.
Based on PDL's first-quarter earnings report, Queen revenue patents totaled $127.8 million of PDL's $149.7 million in sales. In other words, once the remaining stockpile of drugs that bear PDL's Queen patents are sold through, PDL can expect its revenue to decline by more than 85% in the coming three or four years. PDL's more than $2 in EPS could be reduced to just $0.15 in annual EPS in three years, according to Wall Street estimates.
Running the math, PDL's current dividend payout ratio of less than 30%, based on expected 2015 EPS of $2.11, could turn into a highly unsustainable 400% dividend payout ratio by 2018.
2. Annaly Capital Management (NYSE:NLY)
Moving over to the financial sector, and specifically the mortgage real estate investment trust (mREIT) industry, you'll find a plethora of dangerously high dividend payout ratios. One that really stands out is Annaly Capital Management.
Annaly is part of the mREIT niche that invests solely in agency mortgage-backed securities and similar assets. This means its asset portfolio of mortgage-backed securities is protected from default by the U.S. government, although it receives smaller yields on its assets than mREITs investing in nonagency assets.
Generally speaking, lower-interest-rate environments tend to be great news for mREITs, which make money on the difference between the rate at which they borrow and the rate at which they lend. In a rising-lending-rate environment, the opposite is true. Though these companies can remain profitable, their net interest margin usually drops as lending rates rise. Unless you've been hiding under a rock the past couple of months, you're likely well aware of the Federal Reserve's stance on rates and the U.S. economy -- i.e., that an interest rate target hike could be right around the corner. As lending rates return to normalized levels, Annaly's leverage simply won't be enough to counteract a tightening margin spread.
With its dividend projected to total $1.20 for the year and its EPS forecast by Wall Street to drop to $1.03 in 2016, Annaly's dividend payout ratio is poised to spike to 117%.
As a quick note, even though Annaly's dividend could be cut, the company has historically managed a dividend yield of between 8% and 10% over the past 15 years. In short, although this company's current dividend looks unsustainable, Annaly may still make a suitable investment over the long run based on its impressive average yield over time.
3. GlaxoSmithKline (NYSE:GSK)
Just in case you thought unsustainable dividend payout ratios were exclusive to small- and mid-cap stocks, let's have a look at pharmaceutical giant GlaxoSmithKline.
GlaxoSmithKline, like many big pharma companies, is in a transitory process of moving beyond mature drugs that are facing patent exclusivity losses and pushing into new indications. The concern for GlaxoSmithKline -- a company that is heavily reliant on respiratory therapies to treat COPD and asthma -- is that its new therapies (Breo Ellipta and Anoro Ellipta) haven't exactly shot out of the gate. Meanwhile, Glaxo's best-selling drug, Advair, is slated to face a generic competitor as soon as 2016. This once $8 billion per-year drug could see its sales slow to less than $2 billion within the next three or four years.
Frankly, GlaxoSmithKline can't replace its lost revenue quick enough, and that's expected to have a substantial impact on its profits. Wall Street estimates that GlaxoSmithKline's EPS will decline from an expected $2.62 in 2015 to perhaps less than $2 by 2018. GlaxoSmithKline paid out $2.53 per share in dividends over the trailing four quarters. Projecting this out, Glaxo's dividend payout ratio could top 125% within three or four years, which certainly suggests a dividend cut is coming.
The lesson here is simple: Use the dividend payout ratio for your initial screening, and make sure you dig beyond a company's yield in order to get the real story behind its business model.
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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