In the current bull market, it seems out of fashion to talk about dividend-paying stocks. After all, the Standard & Poor’s 500 index garnered an annual return of 20 percent in 2017. When investors are showered with juicy capital gains, who pays attention to dividends in the single lower digits?
But in 2018 the market is growing increasingly cautious about a potential correction, and dividend-paying stocks could become attractive alternatives as many view dividend stocks as safer investments. But are they really? Some investors consider buying dividend-paying stocks an easier path of investment. Since dividends are quite predictable, you don’t have to worry as much about the firm’s fundamentals. Is that true?
Dividends are powered by cash flows. Dividends do not fall from the sky. They are part of profits companies give back to their investors. If you want to become a dividend growth investor, you need to educate yourself about the “sustainability of dividends.”
[See: 7 of the Best Dividend Stocks to Buy for 2018.]
A firm that pays a high dividend yield now is not necessarily a good investment unless the high dividend is sustainable. And that dividend will not be sustainable if the company’s cash flow is not sustainable. For dividends to grow, the firm must expand operations and increase cash flows.
But there is a catch — operation expansion requires capital investment, limiting the funds available for dividend payout. If companies pay too much in dividends now, they may not have enough capital to invest back into operations, which will then damage future dividend growth.
That is why the CEO of General Electric Co. (NYSE: GE), John Flannery, said recently, “We manage the company for total shareholder return, balancing growth and the dividend payout.” Thus, the trick is balancing today’s dividends versus future dividends that are powered by future cash flows.
When screening dividend stocks, it’s recommended to look at the company’s track record. If a company has paid 10 years of dividends without fail, it’s more likely it will continue to do so in the future. It makes sense because dividends are sticky and managers hate to cut dividends for fear of a drop in the stock price from unhappy investors.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
But keep in mind that there’s no guarantee history will repeat itself — a track record doesn’t guarantee future performance. In November 2017, GE announced a 50 percent dividend cut of 12 cents per share — only the second time it had cut its dividend since the Great Depression — so even they couldn’t guarantee sustainability. You must understand a company’s fundamentals to forecast their dividends.
Be aware of “fake sustainability.” Corporate executives view a dividend cut as a last resort, and in order to avoid it they may take drastic measures that could hurt shareholders in the long run. Instead of just looking at the amount of the dividends, keep an eye on how firms are financing them. It will give a sense of how sustainable the dividends are.
When cash flows go down, how is the CFO keeping the dividend intact? If earnings decrease, corporate executives must either generate alternative revenue or cut expenditures to maintain the dividends. Are they selling assets? Are they borrowing more? Are they issuing new equity? Are they investing less?
Asset sales or cutting capital expenditures may enable a company to escape an immediate cut, but the cost could be slower growth in the future, hurting shareholders in the long run. And borrowing more to finance dividends will expose companies to even higher risk of financial distress, making dividends even less sustainable.
Take Mattel ( MAT) — after decreasing earnings while paying out dividends for four years, Mattel finally cut its dividend last year by 60 percent. It’s understandable that the managers did not wish to break the dividend payout streak and were in hopes of weathering through the lows for a turnaround.
But investors need to understand: when Mattel was paying out dividends as earnings were shrinking, instead of taking the dividends as a sign of relief and reassurance from management, be aware that a cost is being paid for hanging on to the dividends. Mattel could have cut dividends earlier and used that money to reposition their business portfolio, or to pay down debt and reduce the risk of bankruptcy. Yes, investors still received the dividends, but it’s also the investors who will bear the costs of a heightened risk of further depressed earnings and a slower turnaround.
Bottom line: Sometimes dividend cuts could be good news, and intact dividends bad news.
Watch out for opportunistic dividend payouts. Research shows that investors exhibit a preference to dividend-paying stocks in certain time periods and are willing to pay a premium for them. In the attempt to jazz up the stock price, corporate executives cater to this preference by initiating dividends when the demand for dividends is high but the company isn’t ready. Those stocks may not have as stable cash flow as peers, and as a result, are more likely to encounter cash flow shortage and have to cut dividends in the future.
[See: 7 Energy Stocks with High-Powered Dividends.]
Compare dividend-paying stocks with other income-generating investments. Top dividend-paying stocks in the Dow Jones industrial average are Verizon Communications ( VZ) and IBM Corp. ( IBM) with a dividend yield of around 4 to 5 percent. Now compare this 4 percent with the 2 percent Treasury bond rate: Investors will earn a 2 percent premium, but bear more risk associated with stocks. In addition to the uncertainty of the 4 percent dividend, the stock price could also fall, rendering a capital loss.
For comparison, Moody AAA corporate bond yield is about 3.5 percent. The AAA bond coupon is safer than the dividend and the bond price is less volatile than stocks. Are you willing to bear the downside risk of owning the stock in exchange for the 1 percent extra income? It’s your call.
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Are Your Dividends Really Sustainable? originally appeared on usnews.com
