- Many investors chase stocks with the highest dividend yield thinking they will bring in high investment returns.
- However, many of these high dividend stocks end up disappointing investors when unsustainable dividends are cut as business prospects and financial condition are poor.
- This article uses real examples to highlight these problems and show you where you can uncover them.
The hunt for the highest dividend yield
There are many investors who invest for dividend income. Many are retirees who rely on dividends as their main source of income. Yet there are others who simply believe that investing in high dividend stocks will help them to achieve above-market returns. However, many end up being disappointed with the poor returns. This is because they focus only on dividend yield and fail to investigate further to check if these high dividends are sustainable. I believe that investing in dividend companies is still an excellent way to get good returns but one must not jump in without a deeper analysis.
What research tells us about high dividend yield stocks
A comprehensive study was done by Ned Davis Research which compares the returns produced by different types of dividend companies. The study spanned a long period from 1972 to 2016 and produced results that are quite counter-intuitive.
What the research found was that highest dividend yield stocks generated the lowest returns among the different types of dividend companies. In fact, this group generated negative annualized return of 1.5% at a time when the S&P 500 returned 7.4%. It is even lower than non-dividend payers, which returned a positive 2.5% per annum. The highest returns go to dividend growers and initiators, which registered returns of 9.9%.
If dividends are good, then why do the highest dividend-paying stocks suffer from such low returns? The answer is one of sustainability of dividends. Many companies are able to offer high dividends for short periods of time but they don’t have the ability to sustain this high dividend payment. As a result, investors get disillusioned and sell the stock.
How investors can avoid these pitfalls?
In order to avoid the negative fate of high dividend-paying stocks, which subsequently have to lower dividends, investors should look out for these potential pitfalls before they jump in to buy the stock.
- Does dividend payment exceed free cash flow generated?
- Are analysts expecting a decline of these dividends?
- Is the company’s business in decline leading to more difficulties to sustain the high dividend payment?
- Has the financial condition of the company deteriorated making them unable to even borrow to finance dividend payment?
We will look at some real-life examples below of high dividend companies with the above-mentioned pitfalls.
Vector Group is a company that sells cigarettes in the United States. Besides that, it is also in the real estate business. The current dividend yield is 6.7%, much higher than the average dividend yield of the S&P 500 company at 2.0%. However, when we analyse deeper, we see some troubling signs.
This stock has pretty much moved in line with its dividends. Its average Dividend Yield in the last 20 years is 8.5%. So the current dividend yield of 6.7%, while high in absolute terms, is actually low when compared to its average dividend yield.
A worrying sign in this company is the fact that dividend payments have way exceeded free cash flow generation. Some of this is financed by an increase in borrowings.
Abercrombie & Fitch is a fashion wear company that caters to young people. As at the beginning of this year, the company has 709 stores in the US and 189 stores outside the US.
Free cash flow used to be higher than dividends in the past. However, as the chart below shows, free cash flow has gone on a steep downtrend in the last 10 years and now fall below dividend payment.
Will the company be able to maintain the current high dividend yield of 5.9%? If we look at the following chart, we see that earnings per share has been on a downtrend for the last 10 years and analysts are not expecting a healthy rebound anytime soon. Business has been bad as the company lost market share to other competitors in the same segment, which could offer better prices.
Analysts are forecasting lacklustre business performance and are therefore also concerned that dividends cannot be sustained. This can be seen by the trend of earnings and dividend downgrades.
And the financial condition has declined through the years, according to the Altman Z-score, albeit in the healthy range. If financial condition continues to decline further, it is even less likely that the company can increase borrowings to finance dividend payments.
With the significant drop in share prices for the last few years (please see next chart), valuation is currently very depressed for the stock and it is trading at a much higher dividend yield of 5.9% compared with its average historical dividend yield of only 1.9%. With stock prices so depressed, a dead-cat bounce rally cannot be ruled out. However, the stock may not be suitable for an investor who wants to look for a long-term stock to hold.
Helmerich & Payne is our final example to highlight things to look for out in dividend stock investing. This company is in the business of contract drilling of oil and gas wells. Current dividend yield of this stock is 5.4%.
Interesting for this company, while free cash flow has been on a decline for the last seven years, dividend payment has significantly increased since 2013. Again, business is poor and dividends may not be sustainable. The company made a loss in 2016 and analysts expect the loss to continue all the way to 2019 as seen from the PE Bands below, which will go into negative territory. While analysts are expecting positive cash flow for the company in the next two years, the level is much lower than in previous years.
Buying dividend-paying stocks is a good investment strategy. Not all high dividend stocks have problems such as those described above. However, to separate the wheat from the chaff, one needs to analyse deeper to make sure that the companies don’t come with those pitfalls described above.