According to the search engine terms that drive people to this site, one of the most common questions is about whether someone should purchase the common stocks of companies with a high dividend yield. It’s a good question: buying, holding, and reinvesting the dividends from high-yielders like BP and Royal Dutch Shell has been one of the best ways to build long-term wealth over the past twenty, thirty, and forty years, and studies of what happens when dividends are allowed to build on themselves undisturbed for long periods of time is the reason why people like Wharton Professor Jeremy Siegel point out that the old Philip Morris was the absolute best investment you could have made over the course of 1926 to 2006 (among your options that existed in 1926).
But the question is incomplete without considering the company that is paying out the dividends. High-yield dividend investing is only a worthwhile pursuit if the dividend is sustainable and built to last for the next 10+ years at a minimum (the reason why BP and Royal Dutch Shell have been so good, despite their periodic dividend cuts, is because their dividends have always rebounded and reached new highs over just about every five-year rolling cycle).
The first mistake that some people can make when thinking about “high dividend stocks” in general is that they don’t look to the profits backing up the dividends. Take for example, Frontier Communications, a company that frequently crops up in most high dividend yield discussions. At the time I’m writing this, the stock trades at $4.75 and pays out a $0.40 annual dividend. With a 8.42% dividend yield, a lot of people wonder whether there is any wisdom with investing in a company like this.
For truly long-term investors, the answer should be a resounding “heck no” because the dividend is not supported by profits. In 2013, Frontier made $.23 in normal profits. The $0.40 dividend is supported by debt, not profits from cash flow. In 2014, Frontier is expected to earn $.25 in profits. The highest projection I can find for the company five years from now is that it will be generating $0.38 per share in 2017. In other words, to support the dividend that the company paid out at the end of 2013, the company would need to be start making higher profits than the most optimistic analyst is predicting 3-4 years from now. This is not dividend investing. This is prayer-based dividend buying.
The second common mistake is that, rather than looking at the profits, investors glibly make their decisions based on dividend histories without looking at dividend growth rates and underlying probabilities. For instance, I wrote this article back in May about Pitney Bowes on Seeking Alpha.
The gist of it was this: despite the high dividend yield around 10%, and a history of raising dividends dating back to 1980, Pitney Bowes was not a good investment because it had an extraordinarily low dividend growth rate leading up to the cut, and its profits had been steadily declining almost every year before the dividend cut. In 2000, Pitney was paying out $1.14 per share in total dividends. Before it cut the dividend in 2013, it was paying out $1.50 in annual dividends. That was a compounded rate of 2.31% over a twelve-year period when inflation ran higher than that. The paltry dividend growth rate, combined with declining profits, was your cue.
Compare that with something like Emerson Electric. During the financial crisis, Emerson’s yield almost hit 6%. The dividend had been growing for 50 years, the dividend growth rate and earnings per share growth rate both hovered near 10% during the ten years leading up to 2009 time of purchase, and the company was in the midst of growing profits and dividends even while its price was plummeting. That’s an example of when you should buy a high yielding dividend stock.
My favorite example from the financial crisis is Aflac. The company has been growing earnings, cash flow, sales per share, and dividends on a nearly linear basis for the past three decades. In fact, during the financial crisis, its premium income, investment income, cash flow, earnings, and dividends all grew from 2008 to 2009. It had the record, the infrastructure, and the growth before your eyes existing at the time it was trading at $11 per share while paying a dividend of $1.12 per share. That worked out to a dividend yield of 10.18%, making it possibly the highest-quality company to ever yield 10% during my lifetime (the potential competitor is the tobacco players during the late 1990s when the lawsuits were brewing). At the time Aflac was paying out the 10% dividend yield, it had been growing by every possible metric and the profits were growing according to every available report, but investors got spooked by the collapse of Lehman and Bear Stearns and pushed the price of Aflac down (even though it was well capitalized and doing most of its business in Japan at the time).
In short, the question “Should I buy a high dividend stock?” cannot be answered without considering the underlying company. Purchasing Aflac yielding 10% during the financial crisis is a much sounder income investment than buying Frontier Communications now at a yield around 8-9%. In the case of Aflac, the profits were growing, the history of dividend growth was rich, and the company had stable finances and high growth rates leading up to the 10% yield point. In the case of Frontier today, the history is bad and the profits do not support the dividend, nor have they for a while. Like anything else, a high-yielding dividend stock can only be as good as the underlying company that is paying it out.
Originally posted 2014-02-07 07:13:18.