With yields persisting close to their lowest points in three decades and interest rates likely to rise, fixed income is a challenging place to be. So it's not difficult to understand why an investor in search of income might be drawn to a banner company bearing a high-yield dividend stock. A regular 4% payout or higher can be a significant boost for income-starved investors.
However, investors shouldn't be misled into thinking these dividends are the optimal choice for generating consistent income. Companies with high dividends may have overvalued stock prices that are vulnerable during bouts of volatility or interest rate hikes – and, rarely do their dividends turn out to be "regular."
The mistake investors frequently make is to view the high dividend in isolation, seizing on the attractive payout while failing to appreciate the range of risks that come with it. That is, investors who only consider the dividend could expose themselves to equity risk if they don't also analyze the company fundamentals. As an illustration, we have to look no further than recent developments at General Electric (GE). GE's stock price dropped roughly 35% this year, with profits hit by restructuring costs and poor performance. Cash flow problems emerged, and on Monday, GE said it was slashing its dividend by 50% to 12 cents a share from 24 cents. The stock's blue-chip status is now in jeopardy.
That means those scouting the market for high dividends should carefully evaluate prospective companies for their growth potential and for the presence of any "red flags." They should also consider broadening their search to include other dividend-yielding stocks — quality stocks that may not have the highest income.
We know companies are encouraged to keep their share prices high. We also know that a dividend cut can wreak havoc on a stock price. And, we have learned that a company in financial peril can help keep its share price afloat by either increasing its dividend or maintaining its already high dividend, thereby preserving the appeal of a large payout while starving its business units of much-needed investments — essentially creating the illusion of financial health.
Setting aside companies that have cut dividends, we can compare the two remaining categories of "dividend payers," companies with stocks that pay high dividends, and "dividend growers," companies that have increased dividend payments each year for multiple years. In short, investors should not exclude the growers for the sake of the payers.
