The only big risk for dividend investors is a company that reduces or eliminates its dividend. It's something you need to avoid at all costs, because falling dividends mean less income and always spark a stock sell-off. It's bad enough to forego income, but worse still when the stock tumbles as well.
Do you know a risky dividend when you see one? The easiest way to identify a risky dividend is to look at the cost of the dividend compared with the operating income and cash flow. Specifically, companies that aren't earning enough to pay the cost of their dividend are extremely risky. When I invest for income, I want a safe and reliable dividend. If I wanted to speculate for big capital gains, I would just buy some highflying growth stocks.
Today, there are over 400 large companies paying high yields. Now, big dividends alone aren't risky. But in my experience, many high- yield stocks are downright risky. Several readers asked me to check out their dividend stocks. I selected two stocks that illustrate exactly how to spot a risky dividend.
The two stocks are similar in some ways. Both are what I call "tax advantaged" dividend stocks. That means they avoid corporate taxes by guaranteeing to pay shareholders at least 90% of their income. And both have a high yield. But that's where the similarities end. The first of these stocks has fallen considerably, and its dividend is at risk. On the other hand, the second company operates in a growing sector and has plenty of cash to fund its dividend.
Don't Bet on Mortgage REITs
Two readers -- Elliott and Mark -- wanted to know more about American Capital Agency (NASDAQ:AGNC). This stock has been crushed in recent weeks, down 22% since early May. That drop has sent the yield soaring, and the $5 dividend translates into a 19.6% yield. That kind of yield should immediately set off alarm bells.
American Capital Agency operates as a REIT. But unlike many REITs, the company doesn't own and operate buildings. Instead, it invests in residential mortgages. That makes the business a bit more complicated. However, this stock plunged along with the entire sector last month. The reason is that Bernanke may curtail bond buying by the Federal Reserve. I've been talking about this recently (read "Why I Want The Fed To Raise Interest Rates").
Rising interest rates aren't good for mortgage REITs like American Capital. That's because this business is extremely sensitive to changes in interest rates. And rising rates aren't good for business. At a recent conference, the company's CEO admitted that the company may be forced to write down its assets. Perhaps the biggest thing haunting American Capital is the dividend itself. Credit Suisse recently reported that most mortgage REITs like American Capital will be forced to cut their dividend payments.
The fall in share price for this stock likely reflects that reality. The bottom line is that the dividend is at risk and a rising interest rate environment isn't good for business. This stock is complicated and difficult to evaluate. And rising rates aren't good for business. My advice is to steer clear.
The Affordability Factor
In 2006, many Americans were living beyond their means. They were buying McMansions, getting a new SUV every other year, and using their home equity loans to finance a highflying lifestyle. The Great Recession gave many Americans a healthy dose of reality. When it comes to dividend stocks, I always want to make sure that the company can actually afford its payments to shareholders. And I want to invest in a company that lives within its means.
Maria wrote in to ask me about Energy Transfer Partners (NYSE:ETP), with a 7% dividend yield. If you're not familiar with the stock, Energy Transfer Partners is an MLP operating over 23,000 miles of natural gas pipelines. I'm bullish on MLPs like Energy Transfer Partners, thanks to the growing U.S. energy sector. The company profits by transferring oil and natural gas through their vast network of pipelines.
One great aspect of this investment is that it isn't directly tied to commodity prices. The pipelines get paid the same amount to transfer natural gas at $4 or at $8. One of the first things I look at is the cost of the dividend, relative to the company's earnings. Energy Transfer Partners pays an 89-cent quarterly dividend. The cost of the dividend is equal to the operating profits of $2 billion a year. Like all MLPs, this stock pays out at least 90% of its operating income to shareholders.
I also like that this company is growing. Last year, the company acquired Sunoco. The result is that revenues surged 7x. And operating income has doubled. Healthy companies mean stable dividends. With my income investments, my primary concern is safety and consistency. MLPs fit nicely into that strategy, allowing me to capture healthy and stable income.
I'm not specifically recommending shares of Energy Transfer Partners. But I would much rather own this MLP yielding 7%, instead of American Capital Agency with its 19% dividend. Chasing stocks like American Capital can lead to investments in companies with unsustainable dividends. And stocks that reduce their dividends get punished. Stick with safer dividend stocks that can afford to pay their shareholders.