Seeking Alpha
Profile| Send Message|
( followers)  

Investors considering high dividend stocks need to answer two critical interrelated questions:

1) How is the company paying for the dividend?

2) Is the dividend really sustainable?

If a company is paying for the dividend with free cash flow, and is making the necessary reinvestment to maintain a solid competitive position in its business, then the dividend is probably sustainable. However, in other cases dividends mask underlying weakness and very rarely even fraud, or simply represent poor capital allocation by management. In the current yield starved environment, blindly investing in dividend stocks is not much safer than buying junk bonds near to par.

Dividends are often an important part of an investment idea. Altria (NYSE:MO), which pays 80% of its earnings in dividends, is the dominant company in an industry that is declining in a slow manner that can be reasonably predicted. Moreover, Altria's businesses generate large amounts of cash, but require minimal capital expenditures, and the management has what I believe to be an excellent record of allocating owner's capital. Similarly, some mature companies such as Wal-Mart (NYSE:WMT) and Western Union (NYSE:WU) have strong competitive positions and reliably generate more cash flow that management can prudently expect to reinvest in the business.

Yet dividend yield alone is never sufficient to justify an investment. Allied Capital issued new equity to pay for its large and growing dividends, all while covering up the massive fraud as detailed in "Fooling Some of the People All of the Time." Some Chinese companies borrow money to issue large dividends allowing controlling shareholders to evade exchange controls and tunnel resources out of US listed entities. In less dramatic cases, a company may commit itself to paying a dividend that becomes unaffordable as industry conditions decline, and/or forgo capital investment necessary to remain competitive in order to temporarily elevate the share price.

An article in this weekend's Financial times, entitled "Growth outside QE required to curb asset prices" , describes a problematic phenomenon:

"...many companies are issuing debt at absurdly cheap levels and using the proceeds to buy back stock or pay dividends that cater to investors and their current preference for yield...The harsh reality for investors is that they would be better served by companies ploughing their piles of cash into productive uses that ultimately boost the broad economy."

Companies face a tradeoff between dividends and capital expenditures. Low interest rates have made capital temporarily cheap, but if a company fails to reinvest in its business it will eventually need to cancel its dividend, and investors will likely take a large loss on their initial investment. In some cyclical industries, it may occasionally be appropriate for a company to dip into retained earnings to maintain a dividend during a bad year. The dividend payout ratio should be calculated based on average earnings across a cycle. However when a company needs to raise capital just for the purpose of maintaining a dividend, trouble almost certainly lies ahead.

All that is solid melts into air

In recent years, several dividend emperors have had to reduce or suspend payments, including: Pitney Bowes (NYSE:PBI), Radio Shack (NYSE:RSH), Frontier Communications (NASDAQ:FTR) , and Century Link (NYSE:CTL). Although these companies may have viable businesses going forward, any "yield pig" who had blindly invested in these companies based on dividend alone, would have suffered.

I have been running screens looking for companies with questionable dividends. Potential targets include companies that are paying dividends that exceed recent profits, have low margins, and low liquidity. Here are the firms that have shown up on several different screens from Finviz:

StockCompanyP/EDividend YieldP/CashCurrent Ratio
APLAtlas Pipeline Partners LP91.206.36%332.600.89
CNSLConsolidated Communications Holdings Inc.*106.008.60%40.490.75
DDominion Resources, Inc.106.903.69%1005.330.74
ENBEnbridge Inc.60.952.62%21.910.93
FTEFrance Telecom28.2613.97%2.560.65
PAAPlains All American Pipeline, L.P.*23.944.00%804.660.99
RGPRegency Energy Partners LP*196.507.20%82.380.83

* Reporting earnings during the week of May 6, 2013.

A closer look at the cash conversion cycle and industry positioning will be necessary before buying put options or entering a short position.

Rather than blindly grasping at any yield available, investors need to carefully look at the sources and sustainability of a company's cash flows.

Source: The Dividend Emperor's New Clothes