Dividend-paying stocks have historically been excellent vehicles to hold for long-term wealth creation. However, there is also a drawback. Investors often see dividends as a safety net. They often believe that a dividend is guaranteed, and it will put a floor under a stock.
But this couldn’t be further from the truth. Dividends can be cut, and furthermore companies that pay dividends can lose money and even go bankrupt. General Motors (NYSE:GM), Bank of America (NYSE:BAC), and General Electric (NYSE:GE), which are all large, “blue-chip” companies cut or eliminated their dividends during the financial crisis. General Motors went bankrupt, and if it weren’t for the government and Federal Reserve bailouts, Bank of America and General Electric would have gone bankrupt as well.
The point is that you need to approach dividend stocks with some skepticism. A dividend isn’t a right, it is a privilege, and it stems from a company’s capital management rather than its blue-chip status or from its high brand recognition. While companies can use these things to their advantage, we have seen many cases in which they don’t, and this is when we begin to see seemingly high-quality companies cut their dividends.
So how do you know what to look for before disaster strikes what appears to be a safe and steady dividend-paying investment?
1. Avoid stocks with excessively high dividends
Stocks with very high dividends may look cheap, but there is a reason that they are trading with these valuations. Just before General Motors went bankrupt its preferred stock offered a 40 percent dividend, making it look like a steal. But you would have lost everything had you bought it. Other companies with high yields that have seen dividend cuts include RadioShack (NYSE:RSH) and J. C. Penney (NYSE:JCP), both of which are struggling retailers that cannot turn a profit. Right before these dividends were cut, they were large and understandably very tempting.
Don’t be fooled. When a dividend is high, it often means that the market is expecting that the dividend is unsustainable, and, while there are some exceptions, the market is often right.
2. Avoid stocks that are not paying their dividends from cash-flow
The idea behind a dividend is that a company generates operating cash-flow, and it can do many things with this money, including rewarding shareholders with dividend payments. However, if there isn’t any cash-flow, then the company shouldn’t be paying dividends. Investors, therefore, need to recognize when a company is paying a dividend from another source. For instance, a company may sell assets in order to pay a dividend, or it may issue debt or more stock. These are all temporary measures, and eventually the company is forced to cut its dividend payment.
With this in mind, you need to look at a company’s cash-flow statement—not its income statement. Income can come from many things, such as a market gain if, for instance, the potential sellable value of a company’s building or a patent increases in value so it can be considered “income.” But a company can’t pay a dividend from paper real estate gains. It needs to generate cash in order to pay a dividend. Thus make sure that a company’s operating cash-flow exceeds its dividend. If it does, then you’re OK.
Disclosure: Ben Kramer-Miller has no position in any of the stocks mentioned in this article.