These days many investors are looking for high dividend stocks. That’s understandable. But what doesn’t make sense is when people ignore the risks of doing so.
What are the risks of high dividend stocks?
Some companies can indeed afford to pay high dividends. But if you are an investor, it’s critical that you understand exactly how that company is generating the cash to pay out those dividends. Let me give you an example. Let’s say the average high quality blue chip stock is approximately 3%. You do some extensive research and find a stock that’s paying 8%. You feel like a regular Dick Tracy because of your superb detective skills.
Great. But before you pop the champagne, take a time out. Get a copy of the company’s financial statements and shareholder letters. If you buy high dividend stocks via funds, read and understand the mutual fund prospectus. Read through those documents and find out where all the money that this firm is paying out comes from.
Let’s assume you do some digging and learn that the company is generating that cash because they transport oil and the price of oil is very high. Sounds good so far, but you are not out of the woods yet.
The Problem with High Dividend Stocks
Keep in mind that those dividends are a double-edged sword. The minute oil prices drop, will the company have the cash to pay out that dividend? Doubtful. And it gets worse. Once all the other investors get wind of a dividend reduction, what’s going to happen to those shares? They’ll plummet.
Of course, the company could take steps to keep that dividend payment flowing even if the profits aren’t there to support it. This happens all the time.
How do companies keep paying out high dividends when they don’t have the profits from operations? They sell assets like buildings, machinery and trucks. And what happens to a company that sells off the assets that help it generate profits? It becomes a company that has a diminished ability to make profits in the future. So while a company might take extraordinary steps to maintain a high dividend rate, it can often do so at its own peril. Another move some companies make in this situation is to pay out a higher percentage of profits in dividends. This may also be a very dangerous move if by doing so the company no longer has enough working capital.
Does this apply to you personally?
Think about high dividends much like you would your own financial situation. Let’s say you earn $50,000 a year and spend $40,000. So you save $10,000 a year, and over many years your savings accumulate to over $100,000. Then one year you get very lucky and earn $75,000. You live it up and get used to the high life. Unfortunately nothing lasts forever, and your income drops back down to $50,000.
The problem is you’ve become used to spending $75,000 and living the life of Don Corleone, so you try your best to maintain yourself in the manner to which you’ve become accustomed. The only way to swing this is to spend down your savings. And it won’t be long before you completely exhaust that $100,000. When that happens, you will be broke.
This is exactly what happens to companies that pay out dividends if they really can’t afford to pay. The owners (shareholders) get used to receiving those nice fat dividend checks. The minute the company cancels those high dividends, the share price crashes. And if the company doesn’t slash the dividend when it should, it will find itself in a diminished capacity to do business and make future profits. Either way, it’s a risky deal.
You can take two steps to avoid this danger:
1. Understand what you invest in.
Read the prospectus and the financial statement. Find out how the company generates those high dividends, because if the money isn’t coming from profits, it’s coming from selling off assets or (worse) taking on debt.
2. Invest reasonably.
I know you’ve heard the expression that if something is too good to be true it usually is. Remember that. If one investment is paying 8% when everything else around is paying less than half, there is something wrong. In most cases, the risk is far higher than you realize. It may be an investment you are better off without.
How are you investing for income these days? Are you making high dividend investments? Are they working? Have you done your due diligence?