The Risks Of Focusing Too Much On Dividend Yields

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by: Aristofanis Papadatos

Summary

Another author advised investors to consider purchasing stocks that offer a higher dividend yield than their historical average dividend yield.

However, this strategy bears great risks.

A relatively high dividend yield may have resulted from a plunging stock due to business deterioration.

It may also have resulted from an elevated payout ratio.

This week I read an interesting article, which advised investors to consider purchasing the dividend champions that currently offer a higher dividend yield than their average 1-year or 5-year dividend yield. According to the article, stocks that now offer a higher dividend yield than their average historical yield are likely to turn out to be bargains. While the article was very well-written and made it to the TOP 10 of the site, I will analyze why it is too risky to follow this strategy. To be fair, the author provided some caveats on his strategy and mentioned the importance of a due diligence before the purchase of these stocks.

To provide a perspective for the risks of this mindset, Target (NYSE:TGT) is a dividend aristocrat, which has grown its dividend for 48 consecutive years. Its average dividend yield during the last 12 months is 3.29% but it is now offering a much higher, 4.18% yield. Therefore, according to the above mentioned article, the stock should be viewed as potentially attractive. However, this way of thinking involves great risks.

More specifically, the market does not offer superior yields for free. This is particularly true in the current environment of almost record-low yields. Therefore, the reason for the relatively high dividend yield of Target is that the stock has plunged 18% since its latest earnings report. The latter proved particularly disappointing, as the company missed the analysts' estimates while its margins pronouncedly shrank. Even worse, the CEO of the company admitted that the company would now pursue lower margins to remain competitively priced every day.

All in all, the competition in the retail sector has strengthened more than ever and is thus exerting great pressure on the results of the company, which seems to have no prospects for return to its growth trajectory anytime soon. Therefore, investors should realize that the superior dividend yield has resulted from the business deterioration, which is not likely to get out of the picture anytime soon. If it was obvious that the headwind would disappear in the near future, then the plunge of the stock would prove short-lived. However, it is almost impossible to forecast when and if a rebound in the business performance will materialize. That's why the market is offering a higher dividend yield than its historical average at the moment. To make a long story short, whenever a stock plunges due to poor business results, its dividend yield automatically spikes but this does not mean that the stock has become a bargain.

Another example of a dividend aristocrat that offers a relatively high dividend yield is Coca-Cola (NYSE:KO). More specifically, while the average 5-year dividend yield of this stalwart has been 3.05%, the stock currently offers a 3.48% dividend yield. However, investors should realize that this stalwart has a good reason for offering an attractive dividend yield.

To be sure, Coca-Cola has failed to grow its earnings during the last 5 years. Nevertheless, it has kept raising its dividend at a significant rate, from $0.255 in 2012 to $0.37 this year. This is a 45% increase in the dividend while the earnings per share [EPS] have decreased 19%, from $1.85 in 2011 to $1.49 last year. Consequently, the payout ratio has greatly increased, from 34% in 2011 to 83.6% last year. This means that the current high dividend yield has resulted from the fact that the stock price has advanced much more slowly than the dividend due to the markedly poor business performance of the last 5 years. As a result, the current dividend yield is higher than the average historical yield but there is good reason behind this seemingly attractive yield.

It is also worth noting that the management of Coca-Cola does not expect earnings growth this year. Moreover, the above mentioned pattern, of higher dividends without proportional EPS growth to support them, is evidenced in many other dividend aristocrats as well. Procter & Gamble (NYSE:PG) and General Mills (NYSE:GIS) are among those dividend stalwarts, which have kept raising their dividend without EPS growth during the last few years. The higher dividend certainly does not render them attractive as long as there are no prospects for them to return to their growth path, particularly given their rich valuation.

The absence of EPS growth and the elevated payout ratios should warn investors that lower dividend growth rates are likely in the future. This is already evident in the case of Procter & Gamble, which raised its dividend at the slowest pace in its history, i.e., 3% in 2015 and 1% in 2016. This deceleration in the dividend growth rate is likely to occur in the case of Coca-Cola as well at some point in the future unless the company returns to its growth path, which however seems unlikely for the foreseeable future.

To conclude, investors should not focus too much on dividend yields when they decide which stocks they will purchase. As demonstrated above, high dividend yields can result from a plunge of a stock due to business deterioration. They can also result from elevated payout ratios, as some companies raise their dividends even though they fail to grow. Therefore, investors should select stocks with a great growth record, strong growth prospects and minimum debt. If they miss the big picture for tiny differences in the dividend yields, they run the risk of receiving slightly higher dividends while realizing major capital losses or lackluster returns at best.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.