If you are seeking to tame volatility in today’s volatile markets, dividend-paying stocks can help you smooth out the price swings. Dividend stocks typically have low volatility and provide a steady stream of income.
In a more unpredictable market, however, even some of the stalwart dividend payers may be less reliable. While you are shopping for dividend income, watch out for these eight red herrings.
When To Avoid Dividend Stocks
- A High Yield to Compensate for a Low Stock Price
Companies offer dividends to entice and keep investors. When a stock price is low, it is important to question why. If it is a momentum stock that has had a reversal of fortune, then stay away.
If the stock passes the value investment test of an undervalued stock with good long-term fundamentals, then it may be a chance to buy a good stock at a discount, and enjoy a dividend income stream.
Some growth investors will decide to move on. As oil prices tumble below $50 a barrel in the fall of 2015, major oil companies such as Exxon Mobil Corp. and Chevron Corp. have raised dividends to keep investors happy during tough times.
Some of these companies will be re-allocated in investment portfolios from growth to income stocks. Other investors will find the stock no longer meets their investment requirement. Warren Buffet recently sold his stake in Exxon, in which he had invested $3.5 billion, and invested $4.5 billion in oil refiner Phillips 66, citing its diversification into the chemical business.
- Dividends Are Paid at the Expense of Growth
A company experiencing lower performance may need to pump cash back into the business and invest in growth. Diverting this money to dividends instead could lead to static or negative growth.
Singapore’s SembMarine, a consistent dividend payer, made the tough but prudent choice to cut dividends this year in the face of lower revenues and earnings. The marine and offshore engineering group have diverted the cash to pay down debt and invest in a new shipyard.
The move puts the company in tip-top shape to deliver on a $1 billion offshore energy contract it received three months after the first dividend cut.
- Slowing Dividend Growth
When a grandfather of dividend payments with a reliable payment history slows its dividend growth, investors are more forgiving. Investors have been weathering recessions with Proctor & Gamble since it started paying dividends in 1890. The consumer products company has recently lowered its dividend to 3%, down from its five-year average of 6.6%.
Asian banks are also grappling with dividend growth. This summer, HSBC chopped 50,000 jobs so it could restore dividend growth after a lull. Investors enjoyed steady dividend growth from 1991 until the financial crisis in 2008.
Standard Charter, meanwhile, halved its dividend to shore up its capital position. Timing may be everything. With a new chief executive coming in the door, disgruntled investors may wait and see how he performs.
- Too Much Debt is Assumed to Pay the Dividend
When cash reserves are low, a company may turn to loans and take on debt to pay for dividends. In these cases, review the company’s debt ratios and cash flow. Will the company be able to sustain the dividend or will it have to cut it to meet its debt obligations?
- High Stock Price, Low Dividend
It is easy to overpay for a dividend stream today due to high price to earnings (P/E) ratios. Even some of the most reliable dividend payers have high P/Es compared to historical norms. In these cases, you have to ask, is the dividend worth the high stock price?
Apple’s $100 stock is paying a dividend of $0.52 a share, a nice bonus for those who already own the stock. From 1987-1995, Apple paid a dividend for a short time, which at times was as low as 6 cents a share.
The share price would not have justified buying the stock if you were only seeking an income stream. For those who were seeking a growth stock, though, they were handsomely rewarded by the stock price appreciation.
- No Dividend Growth
Exxon Mobil may be in a temporary rough patch but by consistently raising its dividend each year it has attracted loyal dividend seekers. A worst-case scenario would be to lose income investors due to no dividend growth.
Let’s say you bought 10,000 shares of Coca-Cola in 1995 when the dividend was $0.22, so you paid $2,200. To maintain your purchasing power, you would need to earn $3,434.90 in dividend payments in 2015 to keep up with inflation.
Coca-Cola, which paid its first dividend in 1920, pays a dividend of $0.33 (or $0.66 before the stock split. In 2012, Coke’s dividend was adjusted from $0.51 to $0.255 after a 2-for-1 stock split.) Outpacing inflation makes the soft drink makers’ long-time investors very happy.
- High-Interest Rates
Interest rates have been very low for the past several years. Investors could easily find higher yields in dividends. When interest rates are higher than average dividend rates, however, a savings bank or even higher earning interest-bearing securities would be the better choice.
- Rate Sensitive Stock
After missing the expected September interest rate hike, the US Federal Reserve says it is committed to raising interest rates in December. Interest-sensitive securities such as mortgage-backed REITs are sure to see profit margins squeezed. These securities profit from the difference in the interest income on the mortgages securities they own and the borrowing costs to purchase them.
The rate rise will also put pressure on utilities and other steady dividend income payers. This may add more risk to dividend-paying equity funds, reports Reuters, as funds invest in emerging market dividend stocks to boost yields.
Dividends are an income vs growth trade-off. High growth stocks do not need to offer dividends to attract growth investors. Investors who want steady income buy dividend stocks. If you are a young investor, you can absorb a higher allocation in growth stocks.
As you get closer to retirement, your stock weighting should shift from growth stocks to income-generating dividend stocks and bonds. Dividend payments can be cut or cancelled but companies will try and cut expenses elsewhere first before risking the loss of investors.
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