If you are chasing high dividend stocks, avoid these pitfalls.

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Old Oct 11, 2017, 4:16pm   #1
 
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If you are chasing high dividend stocks, avoid these pitfalls.

If you are chasing high dividend stocks, avoid these pitfalls.

Summary
• Many investors chase stocks with the highest dividend yield.
• Many of these high dividend stocks come with hidden dangers.
• Article explores with real examples some factors you should look at before jumping into them.

The hunt for the highest dividend yield

There are many investors who invest for dividend income. Many are retirees who rely on dividends as their main source of income. Yet there are others who simply pursue an income strategy believing that investing in high dividend stocks will help them to achieve above-market returns.

What research tells us about high dividend yield stocks

A comprehensive study was done by Ned Davis Research which compares the returns produced by different types of dividend companies. The study spanned a long period from 1971 to 2013 and produced results that are quite counter-intuitive.

What the research found was that highest dividend yield stocks generated the lowest returns among the different types of dividend companies. In fact, the group generated negative annualized return of 1.8% at a time when the S&P 500 returned 7.6%. It is even lower than non-dividend payers, which returned a positive 2.3% per annum. The highest returns go to dividend-paying companies who are able to increase the dividends paid through the years.

If dividends are good, then why do the highest dividend-paying stocks suffer from such low returns. The answer is one of sustainability of dividends. Many companies are able to offer high dividends for short periods of time but they don’t have the ability to sustain this high dividend payment. As a result, investors get disillusioned and sell the stock.

How investors can avoid these pitfalls?

In order to avoid the negative fate of high dividend-paying stocks, which subsequently have to lower dividends, there are some things the investor should look out for before they jump in to buy the stock. We will explain some of these factors with real life examples and charts.

Vector Group is a company that sells cigarettes in the United States. Besides that, it is also in the real estate business. The current dividend yield is 6.7%, much higher than the average dividend yield of the S&P 500 company at 2.0%. However, when we analyse deeper, we see some troubling signs.

This stock has pretty much moved in line with its dividends. Its average Dividend Yield in the last 20 years is 8.5%. So the current dividend yield of 6.7%, while high in absolute terms, is actually low when compared to its average dividend yield.

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A worrying sign in this company is the fact that dividend payments have way exceeded free cash flow generation. Some of this is financed by an increase in borrowings.

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Abercrombie & Fitch is a fashion wear company that caters to young people. As at the beginning of this year, the company has 709 stores in the US and 189 stores outside the US.

Free cash flow used to be higher than dividends in the past. However, as the chart below shows, free cash flow has gone on a steep downtrend in the last 10 years and now fall below dividend payment.

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Will the company be able to maintain the current high dividend yield of 5.9%? If we look at the following chart, we see that earnings per share has been on a downtrend for the last 10 years and analysts are not expecting a healthy rebound anytime soon. Business has been bad as the company lost market share to other competitors in the same segment, which could offer better prices.

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Not only are forecasts of analysts for lacklustre performance, estimates have been undergoing downgrades.

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And the financial condition has declined through the years, according to the Altman Z-score, albeit in the healthy range.

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Since valuation is now so depressed for this stock as seen from the chart below, a dead-cat bounce rally cannot be ruled out. However, the stock may not be suitable for an investor who wants to look for a long-term stock to hold.

Helmerich & Payne is our final example to highlight things to look for out in dividend stock investing. This company is in the business of contract drilling of oil and gas wells. Current dividend yield of this stock is 5.4%.

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Interesting for this company, while free cash flow has been on a decline for the last seven years, dividend payment has significantly increased since 2013. Again business is poor and dividends may not be sustainable. The company made a loss in 2016 and analysts expect the loss to continue all the way to 2019.



Conclusion
Buying dividend-paying stocks is a good investment strategy. Not all high dividend stocks have problems such as those described above. A successful dividend stock investor is one who is able to separate the wheat from the chaff.
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