Beyond the historical precedents in favor of dividend, or high-yield, investing, there are also factors in the current market environment that make these stocks especially profitable. Unfortunately for the uninformed investor, there are more than a few dividend deadbeats in sheep’s clothing that will potentially devastate your portfolio.
According to Standard & Poor’s, dividends have historically accounted for approximately a third of the total return to equities and have less volatility of returns than price appreciation. Dividend income is taxed at a lower rate than ordinary income, making it a good source of cash as well. Currently, corporate balance sheets are ripe with excess cash but economic conditions are not presenting profitable NPV projects. If this cash is not reinvested in capital projects, shareholders will soon begin demanding that firms release some of these funds in increased dividends.
How to spot a deal and avoid a deadbeat
One of the most important aspects of dividend investing is the ability to analyze a company’s motivation for paying a dividend. Investors will see one of two outcomes if the company is issuing a dividend because there is no other use for the cash. Either share price will underperform over time because return on equity is too low to justify the cost of capital, or management will need to discontinue the dividend when profitable projects present themselves.
This scenario can be avoided by analyzing two principal metrics: Growth in operating income and the required return to fund future growth and dividends. Growth in operating income will provide the business continuity and profitability needed to fund future dividends. Many mature companies may be extremely generous in returning cash to shareholders, but are ultimately worth more liquidated if they are unable to derive profits from operations. Investors must analyze the company’s growth in operating income, its payout ratio, and what return on equity is required to maintain or grow the dividend payment.
Dividend yield volatility, through price volatility in the stock, is also an important consideration. During the early stages of market corrections, or declines in the price of an individual security, dividend yields are often pushed up to enticing levels. The dividend yield on many shares is increased and appears on investors’ screens. If the price movement in the security is a chronic symptom of poor financial health, the dividend will eventually need to be reduced to pay for growth or restructuring. This is fairly intuitive, yet still catches many investors off guard. Most dividend investors avoid this by screening for five-year dividend growth. Screening for dividend growth helps ensure that the company is truly a high-yield stock and not one made so by poor price performance.
The best high-yield stocks are those resistant to the business cycle. Few securities have a negative correlation with the market, meaning the share price of the investment tends to increase when general market prices decreases, but many stocks have very low correlations to the market. Of course, analysis of the company’s resistance to the business cycle can be done on a qualitative basis as well. Companies that provide a service or product that is a necessity to its clients irrespective of the economy will be resistant to the general ups and downs of the market. Corporations with several distinct business lines will also be less affected by the economy if the business lines are not highly dependent on one another.
The table below presents my picks for great dividend deals. The companies are not pristine by any count, but fundamentals point to consistent dividend performance and future growth. The return on equity for the three picks is an average of 24.6%, while dividend growth over the last five years is 11.1%. This shows that management has not only been able to find profitable growth but has also been able to grow the dividend at a respectable rate. Debt-to-capital for the three firms is low, implying the ability to raise funds if needed without having to cut the dividend. Dividend yield for the three firms will pay the investor 4.1% per year, a strong return to accompany any price appreciation.
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I recently wrote how I think Johnson & Johnson (JNJ) is the best boring stock out there and should be a part of any core portfolio. The company has aggressively diversified its revenues and is well-positioned to profit from demographic trends. If your moral convictions allow you, Reynolds American (RAI) produces one of the most cyclically resistant products known, tobacco. An annualized 22.8% return since 2000 is a nice addition to a 5.7% dividend yield. Litigation is always a risk with tobacco makers, but a low debt-to-capital ratio and over 10% of the market cap in cash shows the company has plenty of resources. General Mills (GIS) has an impressive return on equity for a food manufacturer. The company makes its products in 15 countries and sells them in more than 100 countries, diversifying its customer base and making it more resilient to problems in any one region.
The table below shows examples of what could turn out to be dividend traps. The dividend yields for these three stocks are, on average, higher than our three dividend deals. This may entice the wayward investor into thinking they are better investments. A more detailed analysis shows many of the traps written about in this article. The companies have had a difficult time providing investors with returns to equity. Whether transitory or more permanent in nature, this is a red flag. Importantly, dividend growth over the last five years is very low or negative, showing a lack of conviction to the dividend policy.
Merck (MRK) faces significant pressure from patent expirations on its major products. Like many drug makers, it has had to generate growth through acquisitions rather than internally, which is not a stabilizing factor for dividends. Pengrowth Energy Trust (PGH), a Canadian oil and gas company, sports an impressive 6.7% dividend yield but has decreased that dividend by 22.9% over the last five years. Profits have been positive in recent quarters, but the industry is highly dependent on oil prices and growth in the economy. EastGroup Properties (EGP) is a real estate investment trust with holdings mostly in the Southwestern United States. Though the high debt-to-capital ratio is largely a factor of the industry, its fundamentals have been weakened significantly from the real estate crisis. Management has been able to keep a positive five-year dividend growth, but an extremely high price-to-earnings ratio exposes the stock to a significant correction.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.