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5 Dividend Stocks You’re Better Off Avoiding

Not every company with a respectable yield is a reliable holding

By Charles Sizemore, Principal of Sizemore Capital

http://invstplc.com/1GompKe

I’m a big believer in dividend stocks. In fact, it’s rare that I buy a stock that doesn’t pay a dividend. Nothing does a better job of keeping management honest than the responsibility of paying shareholders a regular dividend.

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Sure, you can fudge your numbers to make your earning per share number every quarter. But cold, hard cash doesn’t lie. You either have it to pay out … or you don’t.

But that said, not all dividend stocks are created equal. The “perfect” dividend stocks are ones that pay a competitive current yield but also have a good track record of raising the dividend every year. A high-yielding stock that doesn’t raise its dividend on a regular basis is essentially a risky bond with a payout that can be cut at management’s whim.

You also need to see growing revenues and earnings. Without more money coming in, it’s hard for a company to send more in dividends out to shareholders.

And finally, we should always be a little wary of dividend stocks with extremely high yields. Once in a while, you can find a real gem with a fat yield due to a temporary mispricing. But more often than not, when you see an exceptionally high yield, the market is essentially telling you that the dividend is likely to get cut.

So with that said, let’s take a look at five dividend stocks you’re better off avoiding. All might be alluring temptresses, but they will potentially lead you on the path of income destruction.

Dividend Stocks to Avoid: Vale SA (VALE)

Dividend Stocks to Avoid: Vale SA (VALE)Dividend Yield: 9.2%

I’ll start with Brazilian miner Vale SA (VALE). Vale today is one of the highest-yielding stocks you can find with a dividend yield of 9.2%. It’s also a stock whose dividend is almost certain to be cut. Although the board of directors still has to approve it, management proposed slashing the dividend by half in late September.

I have nothing against Vale … or against mining stocks in general. Under the right conditions, miners can be wildly profitable trades. But they are terrible dividend stocks.

Think about it. If you’re buying dividend stocks, chances are good that you’re doing so because you need current income. You certainly wouldn’t complain if you had capital gains. But capital gains are a secondary priority.

And if it’s income you need, stability is of the utmost importance. Your expenses rarely fall, so it’s critical that your income not fall either.

Well … Vale’s business is about as far from stable as you can get. Miners have absolutely no control over the prices they get for the metals they dig out of the ground. They are completely at the whim of the market. Yet they also have very high fixed costs and, often, a unionized workforce with an ax to grind.

Vale’s stock price is down about 75% from its highs of two years ago and down about 90% from its pre-2008-crisis highs. Could VALE rally from here? Sure, particularly if Brazil’s macro situation stabilizes.

But that makes it a potential trade — not a suitable dividend stock.

Dividend Stocks to Avoid: Reynolds American (RAI)

Dividend Stocks to Avoid: Reynolds American (RAI)Dividend Yield: 3.1%

If you’ve read my work for any time, you might be a little surprised to see Reynolds American (RAI) on a list of stocks to avoid. For years, I was a major proponent of vice investing and particularly of tobacco stocks.

But my love affair with Big Tobacco was directly the result of it being perpetually underpriced. Because of the social stigma and regulatory risk, tobacco stocks were the eternal value stocks, high-yielding dividend dynamos that offered market beating returns.

Well, things have changed. Investors have become so starved for income, they’ve actually bid up the prices of tobacco stocks to a substantial premium over the broader market. Reynolds American currently trades for 19 times next year’s expected earnings. The S&P 500 trades for closer to 16 times next year’s earnings.

Remember, tobacco is an industry in terminal decline. The number of Americans that smokes declines every single year. Teenagers today are more likely to have used illegal drugs in the past six months than to have smoked a cigarette. There is absolutely no justifiable reason for a Big Tobacco company to trade at a premium to the broader market.

Right now, Reynolds American sports a dividend yield of 3.1%. Sure, that’s higher than the market’s dividend yield of about 2%. But for crying out loud, shares of the resurgent Microsoft (MSFT) yield 3.3%, and which would you rather own?

Hey, there is a price at which any stock gets interesting. If Reynolds yielded a good 6%-7%, I’d be all over it. But a 3.1% yield is just not higher enough to justify buying Reynolds. This is a dividend stock best avoided.

Dividend Stocks to Avoid: IBM (IBM)

Dividend Stocks to Avoid: IBM (IBM)Dividend Yield: 3.7%

It takes a certain amount of chutzpah to put IBM (IBM) on a “stocks to avoid” list. It is, after all, one of the favorite stocks of the Sage of Omaha himself, Warren Buffett. And if Buffett likes it, it must be fantastic, right?

Wrong.

I have absolute and total respect for Mr. Buffett. He’s a better investor than I will ever be, and I am comfortable admitting that. But he is also human and very fallible. Berkshire Hathaway (BRK.A, BRK.B) itself was a disastrous investment for Buffett. He admitted as much in an interview a few years ago in which he called Berkshire the single worst investment of his career. By Buffett’s own estimation, he’d be twice as rich as he is today had he never bought a single share of Berkshire Hathaway.

This brings us back to IBM. When Buffett first bought it, he was attracted to its long-term service model and its penchant for returning cash to investors via share buybacks.

But there are some big problems here. To start, IBM’s model is not as stable as it appeared a few years ago. Out of nowhere, Microsoft, Google (GOOGL) and Amazon (AMZN) have turned IBM’s business upside down with cheaper and more flexible cloud options. And the billions spent on share repurchases may go down in history as one of the worst allocations of capital in history. IBM stock is down by a third from its 2013 highs, meaning that the roughly 169 million shares repurchased since 2012 were purchased at prices well above today’s. That’s total destruction of shareholder value.

Meanwhile, IBM’s sales continue to fall. Revenues are down 17% since the end of 2012.

At current prices, IBM sports a dividend yield of 3.6% Don’t fall for it. There are better opportunities out there.

Dividend Stocks to Avoid: Verizon (VZ)

Dividend Stocks to Avoid: Verizon (VZ)Dividend Yield: 5.3%

I would also recommend you avoid Verizon (VZ). Yes, it has a fantastic current yield of 5.1%. But dividend growth has been almost nonexistent for years. Over the past five years, Verizon has managed dividend growth of only 2.9% per year.

Yes, that’s beating inflation. I’ll give them that. But it’s not beating it by much.

And I wouldn’t expect much more in the way of dividend growth going forward. Verizon already pays out about 92% of its profits in dividends. So for dividend growth to improve, profit growth needs to step it up a notch.

But just how likely is that? Verizon’s primary business lines — mobile telephony and paid TV — are both mature businesses with saturated markets. Not only does every American over the age of 5 already have a mobile phone, but most have already upgraded to smartphones with data plans. And cell service is quickly becoming commoditized as cheaper rivals like T-Mobile (TMUS) undercut the larger players on price.

And cable TV appears to be in the early stages of long-term decline or, at the very least, a major shakeup. Cable bills have outpaced inflation for years, prompting many Americans – and particularly young Americans – to “cut the cord” and eschew cable service for cheaper internet options.

Verizon isn’t going out of business anytime soon. But it’s a slow-growth dinosaur with businesses under constant attack from competitors. VZ is best avoided.

Dividend Stocks to Avoid: Wynn Resorts (WYNN)

Dividend Stocks to Avoid: Wynn Resorts (WYNN)Dividend Yield: 3.4%

And finally we get to hotel and casino operator Wynn Resorts (WYNN), whose yield is suddenly a little lower thanks to a double-digit spike on Friday, but is considerably higher if you consider if you consider that WYNN occasionally pays special dividends as well.

It’s hard to think of too many sectors less suitable for a stable dividend portfolio than gaming. While many vice industries are recession resistant (people don’t stop drinking and smoking when the economy gets bad), gaming is highly dependent on tourism. And tourism, of course, is very economically sensitive. When the shekels are tight, you avoid taking that weekend trip to Las Vegas.

Wynn’s problems are compounded by the fact that it has major exposure to China’s gaming hub Macau. This would have been seen as a major strength just a few short years ago. But with the Chinese economy slowing and with the government cracking down on conspicuous consumption, exposure to Chinese gamblers is a major risk. No wonder casino stocks including WYNN jumped Friday when China said it might move to support the gaming hub.

Not surprisingly, Wynn’s stock price is down about 75% from its 2014 high. Wynn, perhaps not surprisingly, also had to cut its regular dividend recently, slashing it by two-thirds.

At current prices, the bad news from a slowing China might be fully priced in. But Wynn’s cash flows are still far too volatile for this stock to be a good dividend candidate.

Charles Lewis Sizemore, CFA, is the chief investment officer of investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.

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