It may be unappreciated by the market at this point, but one of the catalysts that set off the recent rise of the stock market was the new, lower tax on dividends. This made dividends substantially more valuable for most investors since they would be taxed at a 15% rate rather than as ordinary income. In the few days following passage of the new tax laws, dividend-paying stocks such as Altria (NYSE:MO), AT&T (NYSE:T), and Kodak (NYSE:EK) enjoyed substantial rises as investors suddenly began valuing dividends more.
Or perhaps I should say "at all." To the momentum folks in the late 1990s, nothing was as anachronistic as the dividend. They were the stuff of utilities and real estate investment trusts (REITs), places where people left their money to die. Folks didn't have time for such silliness after seeing their money triple on eThingamjigs.com. Capital appreciation was the only game in town. Dividends were nothing more than signs that companies were no longer "growth" vehicles.
Fast-forward to today. While the most recent speculative blitz has people ogling companies that lose money in favor of ones that pay it, there should be no doubt that the dividend is no longer the blighted concept that it very recently was. As I discussed last July, even Microsoft (NASDAQ:MSFT), World Wrestling Entertainment (NYSE:WWE), and other non-payers have started returning excess cash to shareholders. And yet, the dividend yield of the companies in the Standard & Poor's 500 sits at 1.5%, less than half of its historical average.
The quest for yield
You might then wonder, with yields at still anemic rates, why I'd be talking about "yield pigs" at all. Yes, overall rates are low, but there are plenty of stocks with extremely high payout rates, and there is a large subset of investors who seek income-generating equities. So while the overall rate may be low, the attractiveness of the dividend is not. Case in point: You can always tell something is in demand because Wall Street will rush out products to meet this demand. Just this last month, Barclays Global Investors released its iShares Dow Jones Select Dividend Index Fund (NYSE:DVY), which indexes 50 high-paying, non-REIT stocks.
Part of the reason that yield may be so low at this point may have to do with the extraordinarily high multiples that investors are willing to pay for stocks these days. One of the reasons that investors cite as justification of the higher multiples is the fact that interest rates sit at post-WWII lows. It's horrible logic, but it is prevalent. There has been a flurry of activity among companies this year to raise or initiate dividends, but stock prices have risen as well, diluting the yield impact of a rise in dividends.
There is an attractive bird-in-hand element to dividend-paying stocks. Companies that pay a dividend are essentially compensating shareholders for some of their risk. And a dividend has the effect of luring investors to a stock when the price suddenly drops. R.J. Reynolds' (NYSE:RJR) stock dropped to the point where its dividend exceeded 10% at a time when it seemed likely that class-action suits could destroy the company. Unquestionably this had the effect of attracting investors to the stock. In 2002, before the big fraud charges came out against WorldCom's management, I took a brief look at the company's MCI tracking stock, in no small part because its dividend yield had suddenly grown to 56%.
But then sanity quickly stepped in. Generally speaking, the market just doesn't leave free money laying around. A high dividend is a message, and one that is as high as 56% is as clear as a rattle on a snake: "I'm toxic."
You might not suffer a horrendous loss buying a big dividend payer, but if you don't stop to ask yourself why the company pays so much, you're not investing very smart. In most cases, a high dividend is a sign of a real threat to principal. So if you're interested in dividend-paying stocks, I have one piece of advice: Don't be a "yield pig."
When pigs fly, they often crash
Yield pigs were well known in the 1980s, a time when rapidly declining interest rates did not translate into a decline in yield demand, regardless of the drop in the risk-free rate embodied by U.S. treasuries -- anything above this rate implies either a risk of loss of principal or a certain depletion of it (for the latter, think royalty trusts). Yield pigs focused so intently on the cash-generating potential of certain investments -- most notably junk bonds -- that they quit even paying attention to the potential for loss.
Here's the thing to remember about dividend yields. They offer cash-generating potential, but they also represent information. There is no such thing as free money on Wall Street. I know, I said this earlier, but it bears repeating. Just like Muammar Qaddafi's famous "Line of Death" turned out to be more like a "dotted line where bad things might happen," there are no hard-and-fast rules. Wall Street misprices and overreacts. Just remember when you see a high dividend yield to ask yourself why it might be so. Because with dividends, more is not better. In fact, the highest-yielding stocks are well-scrutinized by short sellers looking for troubled companies that may suffer further losses.
Setting aside trusts for a moment, I'd be concerned about any company with a dividend yield that exceeds 6%. That doesn't mean you should run in fear from any such company, but you should recognize that the higher dividend means that all may not be well. Specifically, watch for these things:
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The dividend may be at risk. Generally speaking, poor performance and lack of cash to throw around go hand in hand.
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A big dividend due to a onetime event. Companies mainly pay regular dividends, but some pay special ones as well, sometimes to distribute proceeds from an assets sale.
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The company's stock has dropped for a reason. Remember that 56% MCI dividend? Know how many times the company paid it? Once, and that was as the massive fraud was coming to light. More to the point, companies like Altria have seen their dividends skyrocket in times when the potential for massive legal losses seemed highest. Yes, it was an opportunity, but it was also a risk that could have gone the wrong way.
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The dividends aren't regular. This is the case of REITs, which pay a statutory percentage of their pre-tax incomes. If a company does really well in a year, its dividend will be huge, but that's a poor determinant for later years.
- The big dividend includes a return of capital. This is the case with the royalty trusts like Enerplus (NYSE:ERF) or Mesabi Trust (NYSE:MSB). They pay great dividends, but they also build in a return of capital because these trusts have sunset dates (Canadian trusts operate somewhat differently than American trusts). At the end of the trust period, the equity will be worthless. It's important to understand this, since a company that offers a 5% dividend and the potential for long-term capital appreciation may be a substantially better investment than one offering 12% whose capital will eventually be reduced to zero.
The Motley Fool's Mathew Emmert edits the Motley Fool Income Investor newsletter for people interested in dividend-paying stocks. Mathew tracks many of these issues and recommends high-yield stocks that he believes come at lower risk. As in all things, the most important consideration when you're looking at dividend yields is to consider what the stock's price and yield are implying. Just as some of the best short sellers only concentrate on companies once they have fallen close to $5 per share, many see companies with high yields as offering something else: the potential for a complete collapse.
Don't be a yield pig. Sometimes a secure 3% is better than an insecure 6%.
People dancing, people laughing, a man selling ice cream singing Italian songs. Bill Mann owns shares of several dividend-paying stocks, including R.J. Reynolds. For a full disclosure of his holdings, please refer to his profile. The Motley Fool is investors writing for investors.
