3 Things to Remember About Dividend Stocks
Dividend stocks generate valuable income for a portfolio, but if consistent, growing dividends are what you want, don't be seduced by high yield alone.
High-dividend stocks, which have yields well above the norm, may especially beckon some investors now. "With interest rates and bond yields anemic the past few years, many investors seeking better yields have turned to high-dividend stocks," says Kevin G. Bauer, managing principal of BCJ Financial Group in Sandy, Utah. In today's market, a high-dividend stock is one paying a dividend of 4 percent or better, he says.
[See: 10 Stocks That Have Doubled Their Dividend in 10 Years.]
And some dividend stocks leave that benchmark in the dust. As one of 2017's top yielding stocks, telecom Frontier Communications Corp. (Nasdaq: FTR) delivered a whopping 25.97 percent dividend to investors in the fourth quarter. Even at the low end, companies like AT&T ( T) and Macy's ( M) offer yields over 5 percent. The average dividend stock in the Standard & Poor's 500 index typically pays a dividend of about 2 percent.
But not every high-yield dividend stock can deliver consistently. The outlook for growth or the risks associated with those higher yields may be vastly different.
Market volatility also can challenge the dividend's sustainability. "Rising interest rates and lofty stock market valuations may complicate the quest for dividend yield as some of the more popular dividend plays may become less attractive," says Daniel Kern, chief investment officer for TFC Financial Management in Boston. When interest rates increase, some high-yield dividend stocks may rise in favor while others fade into the background. So if you want those high yields accompanied by consistent income and growth potential, you'll need to learn the art of investing in dividend stocks.
Look beyond yield. Double-digit yields can be misleading if you don't understand what's driving them. Bauer says investors often get caught up chasing higher yields and forget their inherent risks. They include the potential for the dividend to be cut or for the stock's price to fall dramatically.
Investors can avoid those unpleasant surprises by understanding how the yield correlates to the dividend and stock price. "If the dividend itself increases, or the price of the stock decreases, then the dividend yield rises," Bauer says. In some cases, companies will hike the dividend to attract yield-seeking investors, but that increase may not be sustainable. Bottom line, "know why a company is paying a high dividend and understand the dividend history of the stock."
Investors also should look at the fundamentals of the company issuing the stock, says Dave Geibel, senior vice president and managing director at Girard Partners, a Univest Wealth Management firm in King of Prussia, Pennsylvania. He recommends reviewing the company's earnings history, dividend payout history, free cash flow and long-term growth rates to gauge the likelihood of a high-yield dividend maintaining its pace. "Stocks that have a long history of paying dividends without reducing the dividend tend to be less volatile than peers' dividends, which may change often throughout the business cycle," he says.
Sector and structure also matter. "A commodity-related business may have variation in the dividend payout, based on the underlying value of the commodity," Geibel says. Although investments structured as master limited partnerships and real estate investment trusts tend to pay higher yields, they're taxed at a higher rate because the income is passed through to shareholders.
[Read: 3 Reasons to Revisit REITs in 2018.]
Recognize red flags. Predicting the movements of any individual stock is an imprecise art, but high-yield dividend stocks may give off certain warning signals that investors shouldn't ignore.
For example, a high-dividend payout ratio from a company taking on debt to pay the dividend may indicate the firm's financials are on shaky ground, says Sean Lynch, co-head of global equity strategy at Wells Fargo Investment Institute in Omaha, Nebraska. "Dividend growers are typically higher-quality companies that have relatively strong cash flow and relatively lower debt ratios," Lynch says. If a stock boasts a high yield but the company lacks a strong balance sheet or efficient generation of cash flow, that yield may be temporary.
Even companies with high payout ratios that aren't taking on debt require a second look. If the payout ratio, which is calculated by dividing the dividend by net income plus non-cash expenses, begins to exceed 50 percent, that's the time to exercise caution, Geibel says. "Dividends are paid out of earnings, and if the dividend payment makes up a large percentage of earnings, this gives management very little margin for error."
If the company goes through a challenging period, the dividend will be cut. Case in point: General Electric ( GE) was forced to slash its dividend payout 50 percent late last year to cut costs and increase cash flow. The measure should save GE $4.1 billion annually, but that savings comes at the expense of investors' portfolios.
There's a simple rule for measuring a high-yield dividend stock's potential, based on the net earnings after preferred shareholder payouts, Bauer says: "Higher is better."
Diversify to minimize risk. High-yield dividend stocks should be balanced with growth stocks. "A high growth stock strategy could lead to massive losses, but the ceiling on gains is much higher," says Steve Azoury, owner of Azoury Financial in Troy, Michigan. At the same time, the potential for dividend cuts, like what happened with GE, adds an extra layer of risk that investors must diversify against.
Investors should also diversify their dividend stocks by sector. "Although sectors such as utilities and telecommunications tend to have high dividend yields, a portfolio concentrated in a limited number of sectors can make for a bumpier ride," Kern says. Dividend-paying opportunities outside a high-yielding sector can smooth the ride in a volatile market. He says tech stocks like Apple ( AAPL) and Microsoft ( MSFT) have consistently paid out higher dividends to investors.
[See: 6 Reasons to Love Apple Stock in 2018.]
It also helps to know what stage the market is in, as some sectors tend to outperform in certain environments, Bauer says. So be aware of how rising rates, inflation and consumer spending are connected to the market's performance and the financial health of companies in different sectors. Dividends can still face pressure from an otherwise healthy company if it's in a hard-hit sector.
More From US News & World Report
