Investors should be wary of the generous dividend yields provided by some companies when it is masking their thin profit margins, high debt levels and underperforming stock prices.
While investors have been drawn to dividend-yielding companies for their yield, these storied companies are now facing lackluster growth and shrinking demand as the economy contracts amid the pandemic.
Dividend investing is attractive to investors seeking yield and income, especially as interest rates have reached lows, but some companies have maintained their yields despite historic losses the last two quarters and plummeting stock prices.
The key factor to watch for is whether the company can pay its dividends in the future, says Jodie Gunzberg, managing director, chief investment strategist at Morgan Stanley, Wealth Management Institutional.
“High payout ratios can be an indicator that companies are using too much of their earnings to pay the dividends, which may inhibit future growth and be an indicator that the dividend may be approaching unsustainable levels,” she says.
Many dividend yields have become elevated from lower stock prices that often reflect a negative view and can make high dividend-yielding stocks risky, Gunzberg says.
Valuations of the companies matter, as the price paid will impact the dividend yield and also the potential downside protection, she says.
“Evaluating the balance sheet debt and linking debt service (coupons or interest) to the expenses on the income statement can be an indicator of the remaining profits to sustain dividends,” Gunzberg says. “The amount of leverage or debt and income used to service that debt will reduce earnings and will likely result in less profits to pay dividends.”
[Read: Best Cloud Stocks to Buy]
Some investors have turned to dividend-producing stocks as a strategy to increase income without turning to fixed-income assets. Dividend stocks provide additional earnings to investors on a quarterly basis. The dividend amount can fluctuate, depending on the profit margin and cash flow of the company.
Dividend stocks “offer another level of confidence to the investor,” says Daren Blonski, managing principal of Sonoma Wealth Advisors in California.
“Investors tend to feel more comfortable buying stocks that offer a consistent dividend,” he says. “Knowing that the dividend is coming regardless of the stock price appreciation enhances the investors’ comfort.”
A high dividend yield isn’t always a good thing because this can suggest a weaker balance sheet, including the amount of debt a company owns.
“Companies with higher risk often offer a higher dividend, so do your homework when analyzing a potential investment,” Blonski says.
“As the old saying goes, there is no such thing as a free lunch,” he says.
Sectors Where Dividend Yields Could Be Cut
The energy sector has the sharpest dividend yield increase but has seen dozens of bankruptcies as the highly leveraged companies faced low crude oil prices, dwindling demand and a supply glut, which wiped out previous profit margins and sunk their stock prices. Even blue-chip Royal Dutch Shell (ticker: RDS/A), one of the largest global energy companies, was forced to slash its quarterly dividend from 16 cents from 47 cents in May, its first dividend reduction since World War II. In the first quarter of 2020, the behemoth reported a net loss of $24 million compared with a profit of $6 billion during the same quarter in 2019.
The dividend yields of the stock market’s 11 sectors were relatively close to their values at the end of the year in 2019 except for the energy sector. The S&P 500 energy dividend yield on July 31 was 6.8%, down from its all-time high of 8% on March 31, but higher versus 3.8% at the end of 2019 and even more than its 2.8% average.
“Clearly, the depressed energy prices are responsible for the high dividend yields, but the question is whether the companies will be strong enough to pay the dividends in the future, which can be better understood by the percentage of free cash flow paid out and making sure the dividends aren’t drawing down cash or credit,” Gunzberg says.
The energy sector is “likely poised for both dividend cuts and valuation contraction” and is facing a potential dividend trap, she says. As of June 30, the S&P 500 energy sector had a dividend yield of 6.1% compared with 1.9% for the S&P 500 and traded at a one-year forward price-to-earnings multiple of 52 times compared with 23 times and estimated earnings growth of 3.7% compared with 10.2%.
While exploration and production companies are performing poorly, integrated energy infrastructure stocks have stronger cash flows and are able to generate heftier dividend yields of 7% to 10%, including Enterprise Products Partners ( EPD), Enbridge ( ENB) and Kinder Morgan ( KMI).
While Exxon Mobil Corp. ( XOM) is still offering a dividend yield of 8.2%, the global energy giant has $69.5 billion in debt. Oil stocks such as master limited partnerships, or MLPs, provide a 10% yield like Magellan Midstream Partners ( MMP).
[See: Best Growth Stocks to Buy]
“Some of them have to offer that dividend yield to keep the investor in the seat,” Blonski says. “Otherwise, they will lose that investor. There is a reason why they are paying a high dividend.”
Instead, investors should turn to sectors that generate a consistent dividend with a prudent management team.
“You’re looking for the sweet spot. You don’t want a company that pays too low or too high of a dividend,” he says.
Dividend yields could be slashed later this year or in 2021 in sectors that are not likely to recover from the pandemic. The consumer discretionary sector that includes retailers and the real estate sector that consists of industrial and office buildings and shopping centers and malls are “seeing pressure as social distancing and remote working is reducing real estate needs,” Gunzberg says.
The financial sector is also experiencing regulatory and political pressures to “use capital for liquidity and lending to keep the economy going, which has resulted in the suspension of some stock repurchase and dividend plans,” she says. The sector is now in a good position based on stress testing and capital requirements.
The consumer discretionary, industrials and energy sectors have had the highest dividend cuts and suspensions in 2020, and “more are likely if the economic picture does not improve,” says Todd Rosenbluth, head of exchange-traded fund and mutual fund research at CFRA, a New York financial research company.
How to Invest in Dividend Stocks in 2020
Instead of relying on a handful of companies to continue providing generous dividend yields, investors can allocate their money into diversified dividend ETFs such as Vanguard Dividend Appreciation ( VIG) or SPDR S&P Dividend ( SDY) in case one or more companies cut their dividends, he says.
“These funds have limited company- and sector-specific risks and invest in a range of companies with long histories of raising dividends,” Rosenbluth says.
Not all dividend-focused ETFs are the same — some target the highest-yielding equities, while others look to companies that have consistently grown their dividends over time, says Mike Loewengart, managing director, investment strategy at E-Trade.
“Exposure to both approaches could make sense for investors seeking equity income,” he says. “While dividend-paying stocks are considered generally safe investments, there’s no guarantee that the company can pay their dividend.”
A diversified portfolio of dividend stocks tends to generate consistent income over time and during varying market environments, says Stuart Michelson, a finance professor at Stetson University.
“Dividend investing will show capital appreciation over time,” he says. “Reinvesting dividends is a great strategy for compounding returns as well.”
Dividend stocks tend to have lower risk, but investors should be wary of stocks with exceptionally high dividend yields because this may be due to a low stock price on an underperforming stock. ETF dividend yields tend to be “somewhat lower than individual securities, but with lower risk and higher returns. The investor trade-off will generally result in better performance,” Michelson says.
Investors could add these dividend stocks, he says:
— AbbVie (ABBV) with dividend yield of 4.97% and earnings per share of $4.70.
— Verizon Communications (VZ) with dividend yield of 4.12% and EPS of $4.62.
— MetLife (MET) with dividend yield of 4.71% and EPS of $7.70.
Dividend ETFs that investors could allocate money in a portfolio include:
— WisdomTree Global ex-US Quality Dividend Growth Fund (DNL) with a dividend yield of 1.74%, expense ratio of 0.58% and 52-week return of 24.47%.
— First Trust NASDAQ Technology Dividend Index Fund (TDIV) with a dividend yield of 2.14%, expense ratio of 0.5% and 52-week return of 21.71%.
— Invesco S&P 500 Quality ETF (SPHQ) with a dividend yield 1.67%, expense ratio of 0.15% and 52-week return of 21.39%.
More from U.S. News