Dividend-paying stocks are terrific when everything goes right — share prices climb and the dividend keeps getting bigger. That’s perfect for the retiree, for example, who needs income plus growth to keep ahead of inflation.
But how do you know when the party’s over? S&P Dow Jones Indices recently removed General Electric Co. (ticker: GE) from the Dow Jones industrial average, a rare move taken when a stock has been hammered or should be replaced by something a little more in line with the times, like GE’s replacement, Walgreens Boots Alliance ( WBA) drugstore chain. GE shares have lost nearly 3 percent a year for the past decade and dropped by about half in the past year, though the dividend yield sits at a handsome 4.7 percent
“Remember, dividend stocks aren’t bonds; you don’t get back par at maturity,” says John Bartleman, president of TradeStation in Fort Lauderdale, Florida. “Capital depreciation cannot be ignored because it can devastate total return.”
Any stock that loses value is a sell candidate. But dividend payers can present a special problem if the share price falls but the dividend keeps coming.
[See: 7 Classic Inflation Hedges and Their Thorns.]
Dividend yield, a common way for comparing these stocks against other income-producing investments, is figured by dividing the past 12 months’ dividend payments by the current price. If the price drops from $100 to $80, the yield on a stock paying $4 a year will jump from 4 percent to 5 percent. With the price down at $50, the yield soars to 8 percent.
Many investors are tempted to shrug off the price drop. If the goal is to earn income, who cares?
But the falling share price is a sign of something, from a temporary blip to trouble in the broad market to impending doom. Experts say this is a wake-up call to get under the hood to see what’s wrong. Bartleman warns that it is unwise to assume the dividend is guaranteed.
“All that matters is total return,” says Matt Topley, chief investment officer of Fortis Wealth in Pennsylvania. “The idea that a stock goes down but I still get my dividend is completely misleading.”
Experts suggest investors follow some simple guidelines:
Pay attention. The biggest mistake, most advisors say, is to ignore a price drop and fixate on the dividend, because the price decline could continue or lead to a dividend cut, like the 50 percent cut GE implemented last fall.
Companies hate to trim dividends, viewing it as an admission of failure that hurts investor confidence, so they do all they can to keep paying. But at some point, the company may be paying more than it can afford and skimping on research and development or other investments that could make the firm stronger.
Look at the payout ratio. The dividend payout ratio is the percentage of net income paid out as dividends. A lower ratio means there’s less chance of a dividend cut if income drops. Many experts prefer a figure of 40 to 50 percent or less.
“An obvious sign that a company may have to cut their dividend is when they are paying out more than they’re earning or that their cash flow will support over time,” says Stephen Schuller, vice president of Dorsey & Co., a wealth-management firm in New Orleans.
[See: 7 Monthly Dividend Stocks for Steady Income.]
Another good indicator is revenue, which is “less prone to manipulation than bottom-line earnings,” says Chris Kim, chief investment officer at Tompkins Financial Advisors in Ithaca, New York.
Study peers and the broad market. It’s not unusual for an entire industry, or the market as a whole, to slump in unison. A cut in defense spending can hurt all defense contractors until it is clear which ones will really be harmed, and the whole market might tumble during an economic shock or some political bruhaha in Washington. A stock falling by itself may be in more trouble than one merely moving with the pack.
Topley says that “80 percent of the move in any stock is a function of the overall market and the stock’s sector. So, individual moves are most of the time not a function of individual fundamentals.”
“Long-term investors can reap handsome rewards when they look through the chafe and buy intelligently during market volatility. But more idiosyncratic volatility [unique to that stock] may create difficulties,” Kim says. “If everything is going down, then buying opportunities sprout up. But if the selling is isolated to a specific sector, industry, or stock, the collective market participants may be telling you something important about future earnings.”
Get past the numbers. Gauges like dividend yield, payout and price-to-earnings ratios are valuable tools, but mainly for sparking more questions. What do the news stories and stock analysts say? Do an online search and see if your brokerage provides access to analyst’s reports. Services like Morningstar highlight news bearing on individual stocks, like analyst downgrades.
“Why is the company sliding?” Kim says. “Analyze the driver behind the slide and ask whether the fundamentals that underlie their business model are intact so long as to maintain the historical dividend.”
High debt levels are an especially important red flag, he says.
Terrance P. McGuire, partner at Ridgewood Investments in the Los Angeles area, says that a dividend-payer can slump for reasons that have little to do with the company: because dividends are less important to investors when stock prices are soaring; because the market is led by non-dividend payers such as technology stocks; or when interest rates are rising, making dividends look less generous.
Be hardnosed. Experts say that the most common psychological reactions to trouble are to stay loyal to a stock that has done well, and to stick with a loser in hope of a turnaround. Studies show that investors hate to book losses, preferring to hope for the best.
[See: 7 High-Quality Dividend Stocks to Buy.]
It’s true that hanging in through the dips pays off for investments in the broad market, which has always gone on to new highs after even the worst crashes, but individual stocks can and do get wiped out. Any individual holding you would not buy today is a candidate for a sale, even if it has done well.
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When to Dump a Dividend Payer originally appeared on usnews.com
