When Is a High Dividend Yield Dangerous?
Dividend stocks are generally good investments. When a company is well-run and routinely making money, it can afford to reward its shareholders with quarterly dividend payments. Companies that have been paying and routinely increasing their dividends for decades or even more than a century are cornerstones of a strong investment portfolio. When looking for dividend stocks, investors often screen for the highest yields. But, when is a high dividend yield dangerous? In this article, we are going to look briefly at dividend stock investing and dividend reinvesting. Then, we will look at when to avoid a too-high dividend when choosing stocks.
A common misconception is that stocks are either ones that appreciate in value or ones that pay a dividend. This is true but only to a degree. For example, as Microsoft grew from a little startup to the tech giant that it is, its stock price skyrocketed and it did not pay a dividend. When it reached the plateau common for successful companies, its stock price slowed its climb and the company started paying dividends (2003). Interestingly, Microsoft stock today sells for four times the price today that it sold for when dividends started. This is a better appreciation than the S&P 500 over the same time span! So, investing in dividend stocks is a good idea. And, higher dividends are better than low dividends but when is a high dividend yield dangerous? It has to do with long term investment and dividend reinvestment plans.
Dividend stocks are not investments where you try to time the market and make a quick profit. They are long term investments (5 to 10 years at least). Although a quarterly dividend check is a nice thing to receive during your retirement, most long term investors reinvest their dividends in company-sponsored dividend reinvestment plans. Because these plans reinvest every cent of your dividend with fractional shares, your investment grows exponentially, fueled by stock price appreciation as well as reinvested dividends. The key issue here is that you expect to hold onto this investment for decades. So, it has to be a safe investment! Thus, you do not want to be tempted by a high dividend yield in a failing stock!
Dividend Stock Screening
The Yahoo Stock Screener is a readily available tool for finding stocks with healthy dividend yields. (And, there are many more.) When using such a tool an investor can screen for various criteria such as market cap, dividend percent yield, stock price, market sector, and more.
To create three examples, we screened for U.S. stocks, large-cap, share price greater than $25, and dividends greater than 2%, 5%, and 10%.
In the 2% category, the screener returned 492 stocks. In the 5% category, it returned 57 stocks. In the 10% category, it returned 6 stocks.
Four out of six of these are Annaly Capital Management which is a real estate reinvestment trust. They borrow short term repurchase agreements and reinvest the proceeds in securities that are asset-backed. They have been in business for 22 years. Selling at just over $10 a share their share price is virtually unchanged from when they started but the stock did trade as high as $20 before the financial crisis and in the $17 range until 2013 when it returned to its $10 range.
Energy Transfer Operating LP stores and transports natural gas. They have been in operation since 1995 but became publicly traded only in 2006. Google Finance only shows stock prices since 2018 and it has traded in the $21 to $25 range.
Icahn Enterprises L.P. went public in 1998 at $10 a share and today trades at $73, having been as high as $117 in recent years. The controlling shareholder is the company’s founder, Carl Icahn, the famous takeover artist. The company is a conglomerate of metals, energy, casinos, food packaging, auto parts, real estate, rail cars, and home fashion products.
In the case of this stock screen, Annaly is not a growth company in that it trades for the same price today as when it went public. In fact, since it traded for $19 a share with the same dividend, you might think of it as a 5% dividend stock fallen on hard times.
Energy Transfer works in a somewhat protected niche in the oil and gas sector by getting paid for storing and transporting natural gas. However, these folks are commonly at swords points with the environmentalists in regard to their natural gas pipelines. The long term fate of this company is tied to the energy industry nevertheless.
Icahn Enterprises is tied to the smarts and success of Carl Icahn which brings up the question of how well the company will do when he is no longer part of the business.
We did not “fudge” these numbers to come up with examples but simply ran a screen like you would. Now, we will look at stocks that might really be dangerous investments.
When Is a High Dividend Yield Dangerous?
A recent article by The Motley Fool looks at three “ dangerous high-yield dividend stocks.” They start by making the same point we did, that dividend stocks are a good part of a strong portfolio and that the ability to pay dividends year after year correlates with long term business success. And, then they note that a too-high dividend should be a warning sign.
Dividend stocks also have a bit of a dark side. Namely, yield and risk tend to be correlated to some extent. This is to say that high-yield (4%-plus) and ultra-high-yield (10%-plus) dividend stocks may lag in the return department when stacked up next to companies paying out say 2% a year. Remember, since yield is simply a function of share price, a flailing business model with a declining share price can lure in unwitting investors with a high yield.
These are the three dangerous dividend stocks they mention and a brief summary in each case of why you should avoid them.
First Dangerous High Dividend Stock: Gamestop
The point that The Fool makes is that Gamestop is tied to brick and mortar retail stores that sell games and accessories.
GameStop’s business model has been completely upended by the emergence of digital downloads from the cloud. In other words, the need to go to a gaming store for new games or accessories is dwindling fast.
Like a lot of companies tied to brick and mortar locations, these folks have tried, without a lot of success, to sell more online.
The company’s stock has sold in the high 50s both in 2007 and 2013 but right now is back where it started in 2002 in the $10 a share range. Their 15.1% dividend is a result of the stock dwindling from $56 a share in 2013 to $11 a share today.
So, if you screen for high dividends and find Gamestop, remember that this stock is in trouble and is not a long term buy and hold prospect.
Second Dangerous High Dividend Stock: BP Prudhoe Bay Royalty Trust
This stock sports an 18.4% dividend yield. It traded for $126 a share as recently as 2012 and today sells for $27 a share. This is another case of a stock that has gone down (80%) in share price without changing its dividend so the company looks great when viewed through the dividend lens. But, it has issues that should concern long term investors.
The problem with this investment is that the money comes from Prudhoe Bay oil production which is soon to run out. The company’s own 2017 annual report suggests that dividends will cease this while the 2018 annual report pushes the cessation of dividends back to 2022. Either way, this is not a great long term investment and anyone who invests at current prices stands a good chance of losing a substantial portion of their investment.
Third Dangerous High Dividend Stock: Barnes & Noble
The nation’s largest bookstore chain has taken repeated hits from the likes of Amazon.com and other online booksellers. Despite repeated downsizing, attempts to operate online, and a healthy 11% dividend as of today, Barnes & Noble is losing the battle and is not a great long term investment of the kind usually associated with dividend stocks.
So, how dangerous are these high dividend stocks? What happens when a company begins to lose business is that as their profits fall the company cuts jobs, cuts stores, and eventually cuts dividends. What happens in many cases is that management does not want to scare shareholders is dumping the stock and sending the share price downward. So, they preserve the dividend and come up with a story about how they are going to fix things.
In the cases of Gamestop and Barnes & Noble, the handwriting is on the wall no matter what management says. The companies will not fold and go away but they will dwindle with lagging stock prices and dividends readjusted to meet reality.
In the case of the Prudhoe Bay Trust, the situation is imminent because the company itself is predicting that the oil is running out and that in a very short time the 18% dividend will go to zero!
The High Stock Dividend and High Investing Risk Take-Home Lesson
The bottom line to this discussion is that investors need to beware of extremely high dividends. High dividends commonly come associated with a stock price that has fallen or with a business model where there is not much expected growth but a good current cash return. Utilities commonly fall into this category as does the capital management company we picked up in our own screen.
Whether or not you choose to invest in any of these stocks with so-so prospects but a high dividend yield will depend on your own view of the fundamentals of the company. To the extent that you have unique expertise and can see a genuine “light at the end of the tunnel” in the form of a high takeover bid or a true recovery of the business, these can be spectacular investments. Otherwise, take care.