Wednesday, September 16, 2009

Are High Dividend Stocks worth it?

As an investor in the accumulation stage, I tend to focus on companies with yields of at least 3% and expectations of future dividend growth. Most of these companies have a history of consistent annual dividend increases which exceeds ten years. I do receive constant criticism from readers however, that I profile very few stocks yielding 5%-6% or more; and then I do feature them I always express my negative opinion on the securities. I am not willing to accept an extremely high dividend payout ratio, which would have been acceptable for a utility or a Master Limited Partnership.

I do realize that most investors want to generate enough income as possible from their nest eggs, which have been accumulated over the spans of several decades’ worth of hard work and sacrifice. The problem with this approach is that investors end up focusing on the end result, without giving much thought about the sustainability and growth of the dividend payment. In other words, although it would take for a 3% yielder 7 years to double your original dividend payment and yield on cost, when the dividend growth is 10%, I believe that investors are better off in a sustainable lower yielder, than in an unsustainable high yielder. The company yielding 6% today that cuts its distributions a few months down the road could end up generating far less income than what you expected.

Some investors also disagree with me that stocks which are yielding 3% – 4% would barely produce enough income to keep up with inflation. The problem with this assumption is that in its goal of chasing the highest yielding stocks, you could end up losing from inflation. For example if you held all of your money in a group of stocks, yielding 8%-10%, and spending all the dividend income produced by your positions, you would lose purchasing power over time. Even worse – if the dividend payment is unsustainable, your yield on cost could even become lower than the current yield on S&P 500, if the company decides to cut distributions. Consider for example Bank of America (BAC), which at the beginning of 2008 would have yielded a cool 6.20%. Fast forward one year later, and the company is currently yielding 0.20%. The worst part is that the yield on your original investment in BAC is now 0.10%.

Compare this to Kimberly-Clark (KMB), which yielded about 3% at the beginning of 2008 but which has raised distributions twice, for a total dividend growth of 13.21%. Your yield on cost is almost 3.5% now, and that is without taking into effect any dividend reinvestment.

A common issue among high yielders is that they have a high dividend payout ratio. This means that the company is paying most of its earnings out as dividends, and doesn’t leave much for reinvestment in the business. If you add in stagnant earnings per share growth, and you basically have a disaster in the making. If that company all of a sudden decides that it needs cash for anything like merger or acquisition or if its earnings drop due to an economic contraction, chances are very high that the dividend payment, which was unsustainable in the first place, would be the first on the management’s chopping block.
Consider Pfizer (PFE) for example. The company spotted a very high payout ratio both in 2007 and 2008. Investors who purchased the stock hoping that this cash rich drug giant would pay a 6%-7% were terribly disappointed when on January 26th Pfizer cut its dividend. The move helped the company save billions, which were much necessary for its acquisition of Wyeth (WYE).

I do realize however that dividend growth is not guaranteed as well. But then I have a requirement of an initial minimum yield of 3% as a margin of safety in case this happens. Chances of a dividend cut are much larger for a company with a current yield of 6%, than for a company yielding 3%. The market is efficient in this section, so you have to understand what risk the high yielders represent, before leaping into the unknown.

Just for the sake of comparison, I identified the components of the dividend aristocrat’s index, which currently yield more than 4%. Of the eleven companies presented, only Kimberly-Clark (KMB) and Cincinnati Financial (CINF) had what somewhat sustainable dividend payouts.



Full Disclosure: Long CINF and KMB

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11 comments:

  1. Are uou worried that ED's dividend is not sustainable?

    ReplyDelete
  2. Richard,

    Since ED is a utility, I think that i am ok if the payout is high there - they have virtually no competition in their target area.
    Now even if it did cut dividends, I won't sell. Utilities that cut dividends, typically start raising them again in a year or so.

    ReplyDelete
  3. Not sure about your stats. This indicates ED's dividend payout ratio is 67%.

    http://www.dividendinvestor.com/?symbol=ed&submit=GO

    ReplyDelete
  4. Check yahoo finance:

    http://finance.yahoo.com/q?s=ed

    EPS (TTM: 2.45
    DPS : 2.36

    Then try to calculate it.

    How does dividendinvestor calculate theirs? Most probably using 2008 EPS..

    ReplyDelete
  5. what do you use to buy stock? I just signed up to sharebuilder. I'm planning on following you. :) I saw sooo many high yielding dividend companies; 14%...15%...18% but they look too good to be true

    check out Anworth Mortgage Asset (ANH)

    ED looks good. I'm going to go long on most of the companies you talk about.

    ReplyDelete
  6. What about REITs, etc.? I found an interesting one in the medical area that returned 11% (bit less now; the stock is up): MPW. Also energy companies, etc. Thoughts?

    -Erica

    ReplyDelete
  7. Yahoo finance is not a reliable source. I always verify with another source. I have found many errors in Yahoo finance stating dividend amount, dividend yield, dividend payment date and so on.

    ReplyDelete
  8. Hey, long time reader, first time commenter.

    I'm about to put together a dividend portfolio for my father. Starting from scratch. I made a post for it on my blog, I'd love some feedback on the first few stocks that I chose to consider for the portfolio.

    the blog is www.perfectmike.com

    ReplyDelete
  9. Well, I have to Disagree on buying Dividend paying Funds, let alone Indvidual stocks for Divs..

    After the pat 10 yrs? You just got your own $ back.. those funds and stocks lost so much last yr an In the Previous Bear of 00-02', it's going to take Yrs to get even again..

    And if Divs were so important? How come Co.'s Like Berkshire doesn't pay any? Taxes play Heavily on Divs as well..

    Just own some Balanced Growth/Value Funds and be done with it.. You're $ grows at a ave arte of 8% apy ( doubles every 9 yrs)
    and you will pay alot less taxes when you take it out..

    ReplyDelete
  10. Buying Stocks? Oh really now!
    And tell me have your stocks Made you a 10% apy these past 10 yrs?

    That's 2% more than Balanced Funds have done and if Stocks or anyother Investment hasn't done that in the past 10 yrs? You're a Sucker to invest in much anything else..

    only 3.4% of private Investors have beaten Bal. Funds .. Not so much for stock Picking reaons, but They take the most Common Mistake out of the equation.. You, the Invesor from making all the usual mistakes from performance Chasing to Panic Selling ..

    and guess why Investment Management Firms an Advisors Hate Bal funds?

    They do the same or better job as they do alot cheaper and are taking their business..

    ReplyDelete
  11. Limoman,

    Check the other posts on this blog, and you will find answers to your questions.

    ReplyDelete

Questions or comments? You can reach out to me at my website address name at gmail dot com.

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