High dividend yields are great if they are sustainable. Too many investors get blinded by a high payout only to be frustrated when the dividend is cut or the stock price tumbles.

In last week’s dividend disasters, we looked at the historically safe consumer staples and telecom sectors and warned about the historically high price multiples investors are paying. Remember, that 3% dividend yield might be nice but that’s all you may get if it takes a few years for earnings to match the lofty price multiples you paid.

In the final part to the dividend disasters series, we’ll look at a mistake made all too frequently by dividend investors – buying the dividend that’s too good to be true.

Yields of 6% to 9% are fairly typical for real estate investment trusts (REITs) or master limited partnerships (MLPs). These companies must pay out 90% or more of income or they face hefty fines and high corporate taxes. Finding a high dividend yield in a stock outside these sectors would be the buy of the century, right?

There are good yields available outside the tax-advantaged structures but don’t think you can buy into them blindly and not get burned. There are a myriad of reasons a stock might have a high dividend yield, and only some of them are good.

Catching a falling knife

The most obvious reason for an unsustainably high dividend is a falling stock price. If the stock has lost half its value and management has not changed the dividend amount, then the dividend yield has doubled. If the falling stock price is solely from sour investor sentiment on the company and not a result of poor performance, then investors might be able to snap up a rebound story.

If the plummeting shares are a result of poor earnings, that sky-high dividend may be next to come down to earth. Management is usually hesitant to cut dividends and the payout can be financed with debt in the short-term but this policy isn’t sustainable. If the company already has a lot of debt on its balance sheet, they may not even be able to save the dividend in the short-run.

When the dividend does get cut on a losing stock, the result can be devastating. One of the most powerful traits seen in investors is that of loss aversion. Investors will often sell out of profitable stocks, taking small gains, but will hold on to losers for a very long time just trying to get back to even. When a dividend is cut, the shares suffer and the investor is left with a price loss and a low dividend yield. The investor holds on hoping for a turnaround while everyday having to look at the stock he never should have bought.

CTC Media

CTC Media (NASDAQ: CTCM) is off more than 14% in less than a month but boasts a 5.5% dividend yield. The $1.7 billion Russian media company posted a growth in sales of just 5% last year versus growth of 27% in the prior year. Though the company raised its dividend to $0.16 per share in May, its track record for payments is volatile. Dividends were cut by almost half in 2011 and the tenuous independence of Russian broadcasters threatens future cash flows.

Potash Corporation of Saskatchewan

Potash Corporation of Saskatchewan (NYSE: POT) plummeted after news that Russian producer Uralkali would not cooperate in production controls that support prices. The stock is down almost 35% from its 52-week high with little support in sight. The projected production increase by Uralkali could bring potash prices down as much as 25% over the next year. While the company has an excellent track record for dividend increases, a significant drop in potash prices would necessitate a dividend decrease. The company raised its dividend to $1.40 per share in July, before the news of increased price competition.

Final Thoughts

High dividend yields are nice but you don’t have to buy into every opportunity that passes your screen. Look deeper for the reasons behind the higher yield and compare it with peers in the industry. A short-term bump in earnings may not be a problem but check it against the company’s past earnings growth. Higher debt may impair management’s opportunity to finance the dividend so be sure the company can get through any rough patches.

Share →

One Response to Dividend Disasters waiting to happen: Part 2

  1. Integrator says:

    Potash illustrates the fundamental problem in resources businesses with otherwise poor barriers to entry where you can’t control supply. If “fake” market controls fall away, look out below.

Leave a Reply

Your email address will not be published. Required fields are marked *