You’ll simply be far better off avoiding these “pie in the sky” yields that eventually end up sacrificing capital in the process.
High yielding assets are often referred to as “yield traps”, simply they have terrible fundamentals, including deteriorating business models and cash flows, and weak balance sheets.
I can attest to the temptation for yield chasing. Over the years, I’m constantly encouraging investors to avoid the fool’s game with regard to “sucker yield” investments.
You’ll simply be far better off avoiding these “pie in the sky” yields that eventually end up sacrificing capital in the process. Just because high dividends appear superior, it doesn’t necessarily mean the highest yield is the best. There’s a point in which being a high yield dividend can be hazardous.
As some readers may know, investments that have a dividend payout ratio greater than 100%, means they’re paying out more than their earnings as dividends. If their earnings don’t recover promptly, dividends can become unsustainable because the company will be unable to reinvest, reducing its capacity to grow in the future.
Also, if the company is highly leveraged, and is having trouble meeting its liabilities, it’s going to be a big red flag for the dividend.
Simply put, we constantly warn investors about avoiding dividend traps as we seek to identify the highest quality companies with a sustainable competitive advantage and a robust operating model. A high-yielding stock with poor fundamentals is often forced to cut its dividend and investors get hit with a double whammy.
Just because "dividends are good," Here’s an example and A company has deteriorating fundamentals but attempts to maintain its dividend policy, usually financing the payout with debt.
One textbook example of this trap is, the owner of many low-quality malls that are being decimated by the rise of e-commerce and the collapse of retailers such as Sears and J.C. Penney. The company reduced its quarterly dividend from $0.2650 to $0.2000 in the fourth quarter of 2017. The payout was cut again in the fourth quarter of 2018 to $0.0750, an overall reduction of 72% from the prior year.
Before the company finally gave in to the realities of its disastrous fundamentals, the stock’s yield was around 18%... and by the end of 2018, had reached 31%. The stock price since that first dividend cut in fourth-quarter 2017 has collapsed 73%, because stock prices generally track dividends, both to the upside but especially to the downside. Even adjusting for those “too good to be true” dividends, investors have faced a -67% total return over the past five quarters.
Play it Safe
Keep in mind, all good dividend yields must be sustainable. Evaluating the sustainability of the dividend is based on a number of factors such as earnings, capitalization, and the dividend payout ratio.
Avoiding investments that pay out more than what they’re earning as dividends may be an obvious strategy, and we believe there should always be an adequate margin of safety with the payout ratio.
Importantly, investments with growing dividends are signaling confidence about their future earnings as they tend to be stable businesses, well positioned to perform throughout market cycles.
"Dividend Aristocrats" are companies that have maintained a policy of increasing dividends for several years. Over the past 40 years, stocks in the S&P 500 index that increased their dividend payout annually averaged a 9.4% annualized return… whereas companies that paid a dividend, but didn’t increase that payout, had an annualized return of about 7%.
The strength of a company’s dividend lies in its ability to continually increase dividend payments to shareholders, and for that reason, these companies have historically outperformed the S&P 500 by a little more than 1% per year and have been slightly less volatile.