A New Year's Resolution: Avoid Dividend Disasters

Adem is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With so many year-end “specials” and the Fed playing the “Grinch” that stole bond yields, dividend paying stocks are definitely the holiday gift investors can’t get enough of. But what’s stopping the gift you’re getting from turning into a high yielding lump of coal?

It’s time to change the way we view dividend stocks -- while it’s certainly nice to get some quarterly cash, dividend stocks can be extremely dangerous. A few of the dangers can be:

1) A high yield may be a red flag that a company is desperately trying to attract investors. This is the most dangerous sign, as we’ll discuss when explaining “pay-out ratios” in a moment.

2) Just as important but almost always overlooked is the fact that paying a dividend might not be a smart use of investor’s capital. To be a good investor, you need to think like a business owner. If you owned a business that stopped investing in itself and innovating, just so it could send a high percentage of its earnings to the bank (investors), wouldn’t you be terrified? It’s frightening that investors change the way they think when shares of the businesses they actually own are represented by stock.

It’s Not That Dividend Stocks are bad; I Just Want You To Invest in Dividends -- Better

Consider it a New Year’s resolution; to stop hunting yield for yield's sake. In fact, if you just want a high yield then I’d much rather see you in a diversified dividend ETF like the Vanguard High Dividend Yield Index (NYSEMKT: VYM). Going this route offers safety through the diversification of the fund. It may not sound like much but investing is all about what you give vs. what you get; with VYM we take “bankruptcy” off the table--a huge plus.

If you’re picking individual stocks, you’re always taking substantial risk. Dividends don’t change that, so you need to evaluate a stock beyond its yield. Start your resolution off right by screening potential dividend picks that fit both of these criteria.

1) The stock offers a chance for significant price appreciation. Any time we invest in an individual company we risk 100% loss of our capital, so we need real upside. Since most dividend payers aren’t growing beyond 10%, the PEG ratio (price to earnings growth) will point us to stocks that are cheap compared to their growth rate. It will also wean out companies that aren’t growing at all or have negative growth (in EPS). Screener #1 is a PEG Ratio below 2.

2). Screener #2 is a pay-out ratio (the percentage of earnings paid out in dividends) at or below 50%. Stocks with high pay-out ratios tend to have terrible businesses, with no organic earnings power. They know that the dividend is unsustainable but the reckless CEO feels the need to do something to keep naïve shareholders on board. Dangerous!

(For a horrifying real life example and the chance to laugh at me, click here.)

So let’s use these criteria as a first step and pick some dividend stocks; for an example, we can screen the top holdings of VYM, which I recommended earlier.

<table> <tbody> <tr> <td>Company Name</td> <td><span>Pay-Out Ratio </span></td> <td>PEG Ratio</td> <td>Meets Criteria?</td> </tr> <tr> <td><strong>ExxonMobil</strong></td> <td><span>29%</span></td> <td>3.65</td> <td><span>N</span></td> </tr> <tr> <td><strong>Microsoft</strong> <span class="ticker" data-id="204577">(NASDAQ: <a href="http://caps.fool.com/Ticker/MSFT.aspx">MSFT</a>)</span></td> <td><span>33%</span></td> <td>1.07</td> <td>Y</td> </tr> <tr> <td><strong>General Electric</strong> <span class="ticker" data-id="203664">(NYSE: <a href="http://caps.fool.com/Ticker/GE.aspx">GE</a>)</span></td> <td><span>50%</span></td> <td>1.22</td> <td>Y</td> </tr> <tr> <td><strong>Chevron</strong> </td> <td><span>29%</span></td> <td>N/A</td> <td>N </td> </tr> <tr> <td><strong>AT&T</strong> <span class="ticker" data-id="205637">(NYSE: <a href="http://caps.fool.com/Ticker/T.aspx">T</a>)</span></td> <td><span>75%</span></td> <td>2.20</td> <td>N</td> </tr> <tr> <td><strong>Procter & Gamble</strong></td> <td><span>58%</span></td> <td>2.16</td> <td>N </td> </tr> <tr> <td><strong>Johnson & Johnson</strong></td> <td><span>47%</span></td> <td>2.27</td> <td>N </td> </tr> <tr> <td><strong>Wal-Mart</strong> <span class="ticker" data-id="206096">(NYSE: <a href="http://caps.fool.com/Ticker/WMT.aspx">WMT</a>)</span></td> <td><span>35%</span></td> <td>1.5</td> <td>Y </td> </tr> <tr> <td><strong>Coca-Cola</strong></td> <td><span>54%</span></td> <td>2.32</td> <td>N </td> </tr> <tr> <td><strong>Pfizer</strong></td> <td><span>44%</span></td> <td>5.11</td> <td>N</td> </tr> </tbody> </table>

AT&T, for example, is the essence of what we’re trying to avoid in a dividend pick. It’s a dividend stock that’s only investment thesis is that it pays a high yield—that’s not enough. Even if we take our two screeners away, it’s hard to make a subjective case for what separates AT&T from its peers; so how will it grow? If it can’t grow, what does that mean for the dividend or for the stock price? Eventually, something’s got to give.

Wal-Mart, GE and Microsoft meet our criteria, which is just the start of our investigation. Once we’re pointed in the right direction we need to ask some tough questions to ensure these companies can maintain the dividend and grow, like:

- Can Wal-Mart continue to grow in Latin America and will big box, low-cost retailers dominate tomorrow?

- Can Microsoft ever turn the corner in mobile, while still holding on to some market share in its core businesses?

- Can GE maintain growth in areas that will matter tomorrow like in turbines and energy efficiency, while reigning in its financial unit?

Your New Year’s Resolution: Finding Dividend Winners, Following Rules

When asking questions about a stock's growth potential, your job is to play Doctor. Think of the world 20 years from now, what will it need—where will it hurt? Does the stock you’re considering make it better?

Whatever the answers to those questions are, you will definitely be on the right track for having asked them. To do so will have meant that you stopped chasing dividends for dividends' sake and had screened for dividend winners that will grow their earnings and dividends in the future.

 


Adem Tahiri has no positions in the stocks mentioned above. The Motley Fool owns shares of General Electric Company and Microsoft. Motley Fool newsletter services recommend Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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