Do Not Let These Stocks Give You 'Dividend Blindness'

 |  Includes: CLX, CPB, CTL, EXC, FTR, RIG
by: Efficient Alpha

By Joseph Hogue, CFA

Though there's probably a more appropriate term, I like to use Dividend Blindness as the single-minded focus on high dividend stocks in investment selection without regard to total return or dividend sustainability.

Having income-producing investments as a part of your portfolio is certainly a good idea but many investors lose sight of the bigger picture that determines overall returns and dividend decisions. Dividend screens are rampant searching for the highest payers, some with varying levels of sustainability. As a result, investors are left with a higher tax bill through the quarterly distributions and a diminishing portfolio of bad investments.

Dividend Sustainability and True Dividend Payers

There is a difference between companies that offer a high dividend yield as a part of their business model and those that offer high yield as a result of some short-term idiosyncrasy in their stock. The tables below show a screen for high dividend paying stocks along with other fundamental detail.

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Frontier Communications (NYSE:FTR) pays an extremely attractive dividend yield but it is largely a result of the decrease in share price. If these shares were trading around their 52-week high the dividend yield would be 7.9%, still attractive but not nearly as much so. Conversely, if Campbell Soup (NYSE:CPB) were trading at its 52-week high, the shares would still yield a 3.3% dividend. Investors must be aware of how price volatility affects dividend yield.

Investors must also understand that the payout ratio, the percentage of earnings paid out as dividends, can severely affect growth potential. Below, we see that CenturyLink (NYSE:CTL) is paying out more in dividends than they are earning. This is sustainable only on a very short-term basis through debt funding but will affect the companies ability to grow over longer periods. To find the implied growth rate given a payout ratio, investors should look at the return on equity multiplied by the remaining percentage of earnings. Doing this makes it evident that the company cannot expect to grow and keep dividends at their current level.

We see a similar problem in shares of TransOcean (NYSE:RIG). The company is paying out 116% of its earnings as dividends, leaving no retained earnings for future growth. Additionally, earnings per share growth over the last five years is negative further hinting that any dividend payments may be unsustainable.

Clorox (NYSE:CLX) currently has a $140 million deferred income tax liability on their balance sheet that is affecting the amount of equity shown and making return on equity not calculable. Adjusting for this charge yields a misleading return metric in the table below, but even using a sector average return on equity of 19.7% yields an implied growth rate of 9.3% This is more than enough to address business needs and sustain the dividend. The company, typical of those in a mature industry, is paying out a large portion of earnings as dividends but not so much as to limit growth.

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Total Return

Investors blinded by high dividend yields may find themselves eating up their nest egg if the stock price falls from grace. After its 6.8% stock price decrease is accounted for, Exelon (NYSE:EXC) has provided investors with a net loss over the last year even with a high dividend yield. Even with lower dividend yields, both Clorox and Campbell Soup offer higher total returns than many higher dividend payers.

Of course, predicting positive stock price appreciation is always easier in hindsight but investors can use a little market common-sense here. Even if you do not believe that the current market price of shares reflects all the available current information, i.e. efficient market hypothesis, the evidence supports some form of efficient markets. That said, prices will generally adjust to reflect a required return by investors for the market level of risk. This required return on the market is subject to estimates and assumptions but between 5-8 percent is a good rule of thumb. Use this when evaluating possible price movements for investment opportunities. A stock with a dividend yield of 3-4 percent could reasonably be expected to appreciate another four percent in a rational market.

If, after evaluating a stock's growth potential then adding in the dividend yield you come to a total return of more than 15% you may need to re-evaluate your assumptions. Without information not already distinctly priced into the market, a total return in excess of 12% is outside the realm of reason for all but the highest risk shares.

Good Fundamentals and Stable Dividends

Investors get sidetracked by chasing returns, whether in price appreciation or dividend yield. Seeking dividend payers in your portfolio does not mean you are immune to the same irrational decisions as growth investors. Growth investors often overestimate future growth potential or overpay for unstable earnings. Dividend investors often overemphasis the need for high dividend yield and lose sight of reasonable growth and return.

As in most things, a moderate approach is probably the best. Look for dividend payers for your portfolio but understand that the company must retain enough earnings to reinvest in working capital and growth. Outside of REITS, a payout ratio above 60% of earnings will leave little for the company to spend on growth. While an extremely leveraged balance sheet may boost return on equity, the interest expense may make it difficult to pay dividends during a cash squeeze.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.