This is a guest contribution by Bob Ciura at Sure Dividend. In the interest of full disclosure, I have not received any compensation for this article. However, they have provided a discount for Lazy Man and Money readers to their newsletter with thousands of subscribers. If you decide to sign up, I would earn a small commission.
It is easy for investors to be lured by stocks with tantalizingly high dividend yields. Running a stock screen could produce multiple high-yielders that look great on the surface, but later turn out to burn investors with dividend cuts.
To be sure, these are not companies operating fraudulent business models. Instead, these are stocks that are “scams” in that they look appealing on the surface due to their high dividend yields, but are actually quite risky because their dividends are unsustainable.
Here are a few things investors should watch out for to avoid unsafe dividend stocks.
What To Look For
High-yield dividend stocks are naturally appealing, especially for investors who rely on income from their portfolios such as retirees. This is particularly the case in an environment of low interest rates. As a result, investors might instinctively gravitate toward stocks with the highest dividend yields. But this is often a mistake.
Stocks with lower dividend yields are far less interesting from an income perspective, but dividend sustainability is a trade-off all investors should be willing to make. To find sustainable dividends, investors should focus on high-quality businesses with manageable debt levels and sufficient dividend coverage. We believe these are likely to be much better investments over the long-term.
With all this in mind, here are three specific reg flags that could indicate a stock is at risk of a dividend cut.
Red Flag #1: Dividend Yield Exceeds 10%
At Sure Dividend, we generally classify a stock as “high-yield” if it possesses a dividend yield of 5% or more. As the S&P 500 Index currently yields 1.8%, a stock with a 5% yield towers above the broader market. But it is actually possible to find stocks with even higher yields of 10% or more. These extreme high-yielders are very attractive by comparison. The trouble is, many stocks with abnormally high yields are mirages.
As a stock price declines, its dividend yield rises. For example, a stock that trades for a price of $100 per share, with a $5 annual per-share dividend, will have a 5% dividend yield. But if the stock price falls to $50 per share, and the company pays the same $5 per-share dividend, the dividend yield is now 10%.
But this is a potential red flag. Plunging share prices are often the result of deteriorating business fundamentals, such as revenue or earnings-per-share. It is important for investors to remember that in order for a company to maintain its dividend payment to shareholders, it must generate the necessary earnings to support the dividend.
Companies that are experiencing declining earnings may not have the ability to maintain their dividend payouts. For this reason, extremely high dividend yields are often a sign of danger. Their sky-high yields are an indication that investors are no longer confident in the sustainability of the dividend payout.
An example of this is oil and gas royalty trusts. We are highly skeptical of many oil and gas royalty trusts’ ability to maintain their dividends over the long run. Therefore, we recommend investors take a cautious view of royalty trusts such as Cross Timbers Royalty Trust (CRT). Despite sporting a yield well above 10%, CRT receives our lowest score for Dividend Risk. Royalty trusts have finite lives due to their limited reserves, and are also extremely vulnerable to falling oil prices, which make them highly unattractive in our view.
Red Flag #2: Excessive Debt Burden
Shareholders are below debtholders within a company’s capital allocation priorities. This is important for stock investors to remember, because common shareholders get paid dividends only after a company’s interest expense is paid. If a company carries an excessive level of debt, it could jeopardize its ability to pay dividends to shareholders.
This is why investors should always analyze a company’s balance sheet before buying its stock, to make sure its debt load is not a hidden danger. There are many cases of highly indebted companies reducing their dividends because of debt. After all, a company that cannot pay its debts is in danger of bankruptcy. For example, the oil price decline of 2014-2016 forced many over-leveraged oil producers—particularly among the Master Limited Partnerships—to cut or eliminate their dividends.
A more recent example of this is occurring among mall-based Real Estate Investment Trusts, or REITs. The REIT business model involves utilizing debt to purchase properties, which are rented out to tenants. But the prolonged erosion in mall traffic in the U.S., exacerbated by the e-commerce boom, has caused multiple over-leveraged REITs to cut their dividends, such as CBL & Associates Properties (CBL).
For this reason, we remain wary of Whitestone REIT (WSR), which currently has a high dividend yield of 8.5%. But it also has a projected dividend payout ratio above 100% for 2019, and an alarming level of debt. The company had a debt-to-EBITDA ratio of 8.4x in 2018, well above the healthy industry norms of 4x-5x. And while it aims to reduce its leverage ratio to 6x-7x by 2023, this is still an excessive level of debt. Unless its cash flow recovers dramatically—which seems unlikely given the troubles facing the retail industry—its debt level is a major red flag as far as the dividend is concerned.
Red Flag #3: Dividend Payout Ratio Above 100%
As mentioned earlier, a company can only pay a dividend if it generates enough profit to do so. No company can continue to pay more in dividends forever if its payout exceeds its underlying earnings. At some point, either the company needs to generate higher earnings to support the dividend, or the dividend must be reduced.
A recent example of this is Vector Group (VGR), a holding company with business interests in tobacco and real estate. Vector Group appeared to be an attractive dividend stock, as it has offered a nearly 10% dividend yield for the past several years. But in each year from 2014-2018, the company’s dividend distributions to shareholders exceeded its earnings-per-share, leading to a dividend payout well in excess of 100%. Because of this, Vector Group recently notified investors it will reduce its dividend by 50% in 2020.
A similar danger could be in store for shareholders of B&G Foods (BGS). B&G Foods is a consumer staples company with food brands including Green Giant, Cream of Wheat, Ortega, Mrs. Dash, and others. But the company’s weakening financial results over the past several quarters resulted in an elevated dividend payout ratio. B&G’s growth strategy of the past several years consisted heavily of debt-fueled acquisitions. However, its spending spree saddled the company with a large debt burden. Interest expense consumed nearly half the company’s operating income over the first three quarters of 2019. In that time, it distributed $1.425 per share in dividends, but generated earnings-per-share of just $1.01. All of this means the dividend could be at risk of a cut.
Avoiding dividend cuts should be among the highest priorities for income investors. Not only does a dividend cut immediately result in less dividend income, but dividend cuts are frequently accompanied by further declines in the share price. This leads to the dreaded “double whammy” of less dividend income, and a loss in principal value.
To help in this regard, investors can focus on a few key metrics to judge whether a company’s dividend is sustainable. While there are never guarantees that a stock will not cut its dividend, performing additional due diligence of these three red flags can go a long way towards reducing the potential risk of a dividend cut.
[Editor: I’m back to give you one more reminder of the Sure Dividend discount for Lazy Man and Money readers.]