Stable payouts and a solid company do not mean much with an overpriced share price.
This article is the first in a series covering dividend disasters and how to avoid one of the oldest tricks in the stock market book, stocks that lure investors with the promise of great payouts only to blow-up in their face.
Investors are loving the dividend plays, and why shouldn’t they? Getting a stable 3% to 5% a year with some capital gains to boot is a lot better than seeing all your returns disappear with the next market crash. It took five and a half years for the market to get back to its 2007 high. Investor money put to work before the crash had little to look forward to other than those beautiful little dividend checks.
The problem is, as everyone rushes in to buy up their favorite dividend payer, the space begins to look crowded. A lot of these companies in the consumer staples and utilities sectors are supposed to be defensive plays for the risk-averse investor. Too many see decades of stable sales growth and dividend increases and think that any price is justified for the peace of mind.
Stocks in the consumer staples and utilities sectors are trading at price-to-earnings valuations higher than 80% of the time over the last 30 years. Shares that usually bring 16 or 17 times their trailing earnings are fetching more than 20 times the earnings they made over the last year.
A couple of these hi-fliers have come down hard lately. Telecommunications darling Verizon Communications (NYSE: VZ) fell almost 9% in the week to May 31st when investors realized that earnings were not going to justify the lofty prices.
Even a stable payout and a history of dividend increases won’t save your portfolio if share prices tumble from overpriced picks. Fortunately, a lot of the companies in the sector have fairly predictable sales and a long history of financial performance.
Before jumping into a dividend play, look at the historical price paid for earnings and other metrics and ask yourself if the market might be asking too much for the shares.
Even after falling on its most recent earnings release, shares of Campbell Soup (NYSE: CPB) trade for more than 20 times trailing earnings. Shares have surged 49% over the last year, despite negative sales growth and a long-term annualized return of 14% in the 22 years before the financial crisis. At 2.4%, the dividend yield is not even that attractive though the company has a good record of special payouts and increases. Unless people start eating a lot more soup, steer clear of Campbells.
Telecom giant AT&T (NYSE: T) dropped more than 5% last month but still trades for 27 times adjusted earnings. Investors, mesmerized by the 5.0% dividend yield, may be overlooking sales growth of just 0.5% last year and a five-year average growth of just over one percent. The shares are down 5.1% over the last year, meaning investor returns are basically flat even with a generous dividend.
Besides the company’s historical price multiple, there are a few metrics you can check to make sure you are getting a good price for your dividend stock. Ultimately, dividends and the stock price are based on earnings growth and you should check the short-term and long-term growth in the company’s bottom-line. If earnings growth hasn’t increased but the shares are soaring, there could be a day of reckoning soon.