March 15, 2009
small change
Beware the dividend trap
Companies with a high dividend yield are great investments only if their business fundamentals are sound
By Gabriel Chen
In this bleak economic atmosphere shrouded by pay cuts and job losses, investors have been shying away from volatile stock markets.
However, a school of investors says that as long as you buy a stock that pays you a good dividend while you ride out this turmoil, you should do just fine. After all, when you factor the dividend into any price appreciation, you enjoy not only income but also growth.
Take the concept of dividend yield, which tells you what percentage the stock returns relative to its price.
Dividend yield equals annual dividend per share divided by the stock's price per share. As the price drops and if the dividend stays the same, the yield will rise. The falls in stock markets mean the dividend-oriented investor has rarely had such an appetising spread before him. That is why now, some analysts are telling investors to buy 'defensive stocks'.
As the name suggests, defensive stocks refer to the stocks of companies whose business performance and sales are not highly correlated with the larger economic cycle. When the economy turns awful, these firms are seen as good investments.
Many of these defensive stocks typically come with attractive dividend yields too. One example is StarHub, which yields just under 9per cent. The telecommunication company is seen as a defensive bet as Singaporeans are unlikely to drastically reduce mobile phone usage unless economic conditions turn very bad.
Another defensive name is Singapore Post. The stock yields at least 6.5 per cent, after the company said it would be sticking to its dividend policy of a minimum of five cents a share a year.
But buying dividend-rich stocks is not without its risks. You may buy into a company with a high dividend yield, but one that is also on its way to the gutter and may not be able to afford to pay any dividend in the near future.
While the best dividend-friendly companies are the ones that make their business decisions with their shareholders in mind, the reality is that when the going gets tough, companies - even dividend-friendly ones - can slash dividends. And there is nothing to stop companies from cutting the dividends again or suspending the payments indefinitely.
While dividend cuts may be hard on shareholders who are reliant on such payouts, they are often necessary medicine during hard times. Companies may cut or reduce dividends in order to conserve cash, pay off debt and increase financial flexibility.
JPMorgan recently cut its quarterly dividend from 38 US cents a share to five US cents a share in an effort to preserve capital. Investors in American companies as diverse as Motorola, Dow Chemical, General Electric and Pfizer, as well as Europe's insurance groups AXA and Allianz, have also seen their dividends shrivel.
Closer to home, a growing number of Singapore companies are also resorting to dividend cuts.
United Overseas Bank cut its final dividend this year to 40 cents a share from 45 cents a share a year ago. Parkway Holdings did not even pay a final dividend this year. Last year, the hospital operator declared a final dividend of 4.51 cents a share.
Be careful about jumping into a stock just because the yield may be high. It is enticing to snap up stocks on the assumption that even if they are unlikely to rebound from their lows soon, they will at least provide a reasonable income.
The thought is a sound one, but investors should take a step back and consider just how secure those payouts are. If you look at recent records of major US financial institutions that have cut their payments, you will find an uncanny pattern of dividend cuts and then massive failures. Some examples include Fannie Mae, Freddie Mac, Wachovia Bank, Washington Mutual and Lehman Brothers.
Take a leaf out of my experience with NovaStar Financial. NovaStar was organised as a real estate investment trust and it reported high taxable income that it paid out in dividends. In fact, NovaStar was a money machine. Riding on the coat-tails of the booming US housing and mortgage industries, the stock was yielding over 15 per cent for me. But it was also a sub-prime lender, which meant it specialised in lending to borrowers with a tainted or limited credit.
The stock has since imploded and has been delisted, and I have not received dividends since late 2007.
The collapse was not surprising. After all, how viable is a business that is built on lending money to people who cannot pay it back?
This begs the question: Why did I buy NovaStar shares? Maybe it was the prospect of juicy payouts, or the thrill of owning a stock that had more than quadrupled in just 16 months.
Like bankers who paid themselves millions of dollars for packaging risky loans or greedy home buyers who signed up for mortgages they could not service, I threw out common sense when I sank money into something that turned out to be a house of cards.
Companies with a high dividend yield may be great investments if the rest of their fundamentals fall into line. But be careful when the earnings and the business model do not add up and look questionable. For all you know, that could be a sure sign that not all is right with the firm.
And if that is the case, then the big fat dividend promised might not be worth it after all.
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