Most people like a good dividend. While it’s nice to get soaring stock prices, a steady dividend pays the bills during more difficult markets. Given the collapse in interest rates recently, more investors have turned to dividend-paying stocks. Many investors own these higher-yield dividend stocks to replace bonds. That’s fine. It’s a valid strategy.
However this approach exposes investors to more risk. With a bond, you are guaranteed to get your principal back at maturity. Sure, the interest rates are low, as of late, but your capital is safe unless the issuing company defaults. With government bonds or CDs, the risk is virtually nil. Stocks, by contrast — even conservative ones — run the risk of dramatic capital losses. Many of the U.S.’ soundest companies still fell 30%-40% during the financial crisis.
In today’s market, we again find big risk in many beloved dividend-paying companies. It makes sense to try and grab decent dividend stocks … but you must avoid ones where there is sizable risk of large capital losses, offset by only modest potential upside.
These three stocks appear to be yield traps, and should be avoided heading into 2017.
Yield Traps to Avoid: McDonald’s (MCD)
As recently as November, McDonald’s Corporation (NYSE:MCD) was having a so-so year. However, MCD stock is up 7% since then, and managed a gain of 3% in 2016.
MCD stock is now trading at 22x earnings. At first glance, that seems overpriced but nothing horrendous. But deeper inspection turns up more problems. Revenues hit $27 billion in 2011. Since then, they’ve declined to $25 billion today. That’s particularly bad after considering that this isn’t adjusted for inflation. Book value has now gone negative. McDonald’s has more than doubled its outstanding debt over the past five years to buy back stock and pay dividends.
The share buyback and dividend is the main thing keeping McDonald’s stock elevated. But with years of falling net income and flat-to-down revenues, there’s only so much that financial engineering can accomplish.
MCD stock pays a nice yield, and it has traditionally grown that dividend rapidly. But with dividend payout now at 67% of earnings, and the business shrinking, there’s little upside for MCD stock or its yield.
Yield Traps to Avoid: Altria Group (MO)
Altria Group Inc (NYSE:MO) is a trusted name among dividend investors. The company pays a 3.6% yield, and has grown that at a 9% rate over the past three years. However, this is simply inadequate given the risks.
Tobacco is a slowing dying industry. That’s not new information. And tobacco stocks have been huge winners over the past 30 or 40 years. But that came due to low expectations — tobacco companies routinely traded at sub-15 P/E ratios, as investors fretted about the future. Now that tobacco companies have transformed themselves into sexy yield plays, P/E ratios have exploded.
MO stock now fetches 25x earnings. That’s too high, given the company’s slowing, declining industry. Also consider that it trades at 45x book value. There are hardly any assets here underpinning the company’s valuation. That’s fine if your brand is worth a great deal, but tobacco brands are inherently declining assets, as governments regulate them out of existence.
There’s nothing wrong with buying a slowing dying company, but you should be able to do so at much better prices.
Yield Traps to Avoid: General Mills (GIS)
Who doesn’t love cereal? Unfortunately for General Mills, Inc. (NYSE:GIS), the answer is millennials. Demographics are a huge headwind for GIS stock going forward, particularly as millennials start having kids and electing not to buy them General Mills products.
GIS stock is still trading at 23x earnings. And that’s way too high, given the company is firmly stuck in reverse. Revenues dropped over 6% over the last year, and free cash flow generation plunged 20%.
In 2011, General Mills earned $2.70 per diluted share. Over the past 12 months, that figure is at $2.68. Sure, you can blame the strong dollar or shifting consumer preferences for the shortfall. However, regardless of how you look at it, five years of stagnant business evolution, with 2016 tipping into a serious downturn, doesn’t bode well.
I know GIS stock pays a nice dividend, and has shown solid growth over the past 10 years. But at today’s 69% dividend payout ratio and with the business losing ground, we’re likely to see GIS stock turning soggy on owners sooner or later.
As of this writing, Ian Bezek had no positions in any of the aforementioned stocks. You can reach him on Twitter at @irbezek.