A great dividend stock can do wonders for your portfolio … but not all dividend stocks are created equal. Make sure you know these red flags for dividend stocks
Pop quiz …
Beginning in 1926, dividends have accounted for what percentage of stock investing profits in the S&P 500?
I’ll throw you a few factoids in case it helps …
Right now, the S&P 500’s average dividend yield is 1.75%.
Its all-time minimum yield was 1.11% in August of 2000, with a max of 13.84% in June 1932.
Below is a chart of the dividend yield since the late 1880s.
Source:Multpl.com
Got your guess?
The answer is “nearly half.”
Since 1926, dividends have been responsible for nearly 50% of stock investing profits in the companies that make up the S&P 500.
That’s extraordinary.
It also tends to shock a good deal of investors who assume that it’s capital appreciation that drives the vast majority of market gains.
As investors, we tend to focus on finding the high-flyers — the next Amazon, or Apple, or Microsoft. And there’s nothing wrong with that. In any balanced portfolio, there’s a place for different strategies.
But by that exact same logic, there should be a place in your portfolio for quality dividend stocks. Think of them as the “bread-and-butter” of your portfolio. The blocking-and-tackling. They’re not flashy, but they can they do wonders for your returns over the long-term.
This is because when you invest in a solid company that pays a good dividend, and it consistently raises that dividend year-in-year out — and then you reinvest that dividend — it’s one of the most surefire ways to create wealth.
***But being a dividend investor offers another benefit — a way to sniff out troubling fundamentals in a company’s core operations
You see, the condition of a company’s dividend program is often reflective of the health of the company’s underlying business.
That’s because dividends are paid out with free cash flow that’s left over after paying for the cost of doing business (Well, this is the case when times are good — some troubled companies can use debt to pay dividends to maintain an appearance of health.).
Now, we recently learned that the overall condition of U.S. dividends is in good shape.
Specifically, U.S. companies spent nearly half a trillion dollars in dividend payments last year — the eighth consecutive year of record payments.
The S&P 500 paid an aggregate $485.48bn to shareholders. That’s up 6.4% from a year ago.
And looking ahead to 2020, some analysts are even calling for dividends to return to double-digit growth rates.
But, as you know, great “big-picture” averages can mask horrible “small-picture” specifics.
Any General Electric investor knows this all-too well.
GE was once a dividend aristocrat — think “the elite” of dividend paying companies. As recently as 2011, General Electric paid a whopping 5.8% yield.
But in November 2017, due to fundamental weakness in its core business, it slashed its dividend in half — going from $0.24 to $0.12. it was only the second cut the company had ever made since the Great Depression.
But it was about to get far, far worse …
Last year, General Electric investors received a divided payment of — get ready for it — $0.01 per quarter.
It’s an epic fall from grace for this former blue-blood dividend stock.
So, as investors, how do we find the best dividend stocks? And the flip side of that, how do we use dividends as a barometer to sniff out potentially hazardous stocks?
Famed investor, Louis Navellier, recently gave us a roadmap.
***Five warning signs for dividend investors
Louis is a big dividend investor. In fact, one of his portfolios for Growth Investor subscribers even goes by the name “Elite Dividend Payers.” I’m scrolling this portfolio as I write, seeing yields including 9.5%, 8.3%, 8.5%, and 7.6%, among many others.
Last week, Louis wrote to subscribers about five warning signs any dividend investors needs to keep an eye out for. It’s a great roadmap for all of us, so let’s follow along.
The first warning sign is deteriorating cash flow.
From Louis:
When determining if a company’s dividend is sustainable, the first place you should look is the company’s cash position. Consider both the cash on the company’s balance sheet and its ability to generate cash flow. If a company’s cash flow is deteriorating or it’s taking enormous amounts of debt, its ability to pay a dividend is also deteriorating.
The second red flag is a credit downgrade.
Louis tells us that, usually, a credit downgrade precedes a cut in a company’s formal credit rating.
Obviously, companies don’t want this to happen. That’s because if their credit ratings are cut, it puts them at risk of higher borrowing costs when they issue new debt.
So, when a credit downgrade does happen, companies often slash their dividend in order to preserve cash flow, as well as its credit rating.
The third red flag is weak fundamentals.
Back to Louis:
Earnings announcement season isn’t just about revenues and profits. It also reveals which companies can sustain their corporate buyback programs and dividend payments.
You see, when a company has weak fundamentals, it can’t rely on sales growth or earnings growth to improve its cash flow. Instead, it has to look at what it can cut to make up the difference and free up cash. The first step is usually to eliminate stock buyback programs and the second step is to cut dividends.
In most cases, it doesn’t matter how many consecutive quarters a company has paid a dividend or how consistently it’s increased the payment until now. Many companies are going to prioritize cash flow first because that’s the way they keep their businesses running.
A classic example of this is Kodak.
Though the undisputed king of cameras and imaging technology in the 70s, Kodak began to struggle in the 90s as the print photo industry began to collapse. Kodak didn’t keep up with technological changes.
The effect on the dividend?
In October 2003, the company slashed its dividends by 43% to 25 cents quarterly, decreasing the dividend yield to 1.9%. The company claimed the drastic cut was due to a new business strategy that required investment in newer technologies. That tanked Kodak’s stock 18% … in a day.
The fourth red flag from Louis is a suspended stock buyback program.
Louis tells us that when a company cuts back or suspends its stock buyback program, it could be a sign of trouble.
Specifically, when a company suspends stock buybacks, it often means that the company doesn’t have sufficient cash to support the program. Alternatively, it could have taken on too much debt to buy back stock.
Either way, if a company doesn’t have enough cash to support stock buybacks, the dividend is next in line to be cut.
Finally, the fifth red flag to watch out for is a climbing yield based on a falling stock price.
As a company experiences challenges to its core business, the stock price often tumbles as investors see cracks forming in its operations. However, this can also be dangerously alluring …
From Louis:
What’s interesting is that when this is happening behind the scenes, the company’s dividend yield is growing more attractive to yield hungry investors. That’s because the dividend yield is rising, as the company’s stock price is falling.
But if these investors don’t look under the hood to uncover the real reason for rising dividend yields, they could be in a heap of trouble when the company ultimately can’t maintain its payouts and cuts the dividend.
An example of this was General Motors.
In the mid-2000s, GM looked like an attractive dividend stock. Its yield was over 10%, and the company had reliably paid a $0.50 dividend from 1997 through 2005. But that 10% yield was happening not because business was great … but because GM shares had plunged from over $60 to under $20.
It was too good to be true, and in 2008, GM slashed its dividend to $0.25.
Wrapping up, yes, a quality dividend stock can be the bedrock of a strong portfolio. But wise investors keep track of the health of the dividends of their stocks — after all, this is a great way to see smoke before fire.
If you’d like Louis’ help in finding great dividend stocks, click here.
Have a good evening,
Jeff Remsburg
