As the stock market continues to rise, the road for yield-seeking investors becomes increasingly bumpy.
Yields from conventional blue chips are barely worth seeking, as the S&P 500 Index is returning a measly 1.9%. Yet the stocks that are paying serious dividends bring significant risk and, more often, the certainty of loss, as dividends end up being paid out of capital.
In fact, there are many ways in which high dividends can prove to be illusory… and in the worst cases, companies end up being nothing more than giant Ponzi schemes.
So what, then, is the right amount of yield for intelligent income investors? Let’s take a look…
Dividend Danger Zone
Sometimes, high yields are tied to an asset with a finite lifespan. In this case, investors are buying a finite annuity rather than a perpetual yield.
The most spectacular example of this is Great Northern Iron Ore Properties (GNI), which currently boasts a $2.60 quarterly dividend and a whopping 51% yield. The snag is that GNI’s rights to royalties from Mesabi Range iron ore mining expire in June 2015, after which the company will be wound up and its modest assets distributed.
The company may or may not be a good deal at its current price (around $20), but it certainly wasn’t a good deal at $68, where it sat as recently as the beginning of this year.
And even though Great Northern is an extreme case, many master limited partnerships (MLPs) in the energy sector rest on an asset base that has an essentially finite life.
If you’re receiving an 8% dividend today from a company that’s renewing itself, that’s a very good deal… but an 8% annual dividend from a company whose asset will be exhausted in 2030 gives you a true yield of only 3.06%, as the security will be worth zero in 2030, and you have to amortize what you paid for it.
Some MLPs try to avoid this criticism by continually buying new properties, which theoretically allows them to avoid becoming a finite income stream. That’s great – if the new properties are financed out of operating cash flow, so that both the dividend and the capital investment are sustainable.
In today’s market, however, new properties are very often financed through new equity issues – in which case the company is essentially a giant Ponzi scheme, using new investors to finance the money that sustains dividends for the old investors. Needless to say, it’s very hard to tell whether the new acquisitions are legitimately financed, but new equity issues for such companies should be treated with deep suspicion.
A Rising Rate Sinks All REITs
Even outside the MLP space, high dividend yields can be unsustainable.
PDL BioPharma (PDLI), for example, pays a 7% dividend that’s covered by royalty income from pharmaceutical patents. Unfortunately, its highly profitable “Queen” patents expire at the end of 2014, and while PDLI will continue operating, it’s not clear what revenue will look like going forward or whether the company will cut its dividend.
Meanwhile, some high-dividend payers have operations and profits that are perfectly sustainable… but they’re highly vulnerable in a recession or if market conditions change. The banks zapped investors this way in 2008.
In fact, Citigroup (C) not only reported huge losses and reverse-split its shares 1 for 10, but it cut its $0.54 quarterly dividend, which doesn’t appear to be coming back. Even JPMorgan Chase (JPM), the most solid of the big banks, suffered a five-year gap before restoring its quarterly dividend to pre-2008 levels.
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These both have juicy dividend yields around 11%, but are hugely vulnerable to rising rates, which would cause their mortgage bond portfolios to decline in value – and would shrink the “spread” between short-term rates on the money they borrow and long-term rates they receive.
Searching for Valuable Heirlooms
Instead of stretching for yields – especially in current markets, where valuations have risen so far that most shares don’t yield much – it makes much more sense to look for stocks whose dividends have increased every year for several decades.
I call these “Heirloom Stocks.”
Not only are their current dividend yields highly secure, but they’re also likely to increase substantially over a lengthy period. In fact, in 20 years’ time you could be receiving higher dividend yields from Heirloom Stocks than from today’s high-yield stocks, even if the latter are still in business.
For example, Procter & Gamble (PG) currently yields just 2.9%… but it has a history of yearly dividend increases dating back to 1954, the longest current streak of any company. What’s more, its dividend has increased by a multiple of 7.4 times over the last 20 years.
If it repeated that performance in the future (and, of course, it might not), your dividends in 2034 would total $4.71 per quarter, a yield of 21% on today’s share price.
As another example, Medtronic (MDT) currently yields a mere 1.8%. However, it too has increased its dividend every year for more than 30 years, and over the last 20 years has raised its dividend by a factor of 24 times. Based on that performance, MDT would be paying about $7.50 per share in quarterly dividends by 2034. That’s a yield of no less than 44% on your investment today.
Bottom line: Greed is generally good – but not when searching for attractive dividend yields!