Dividend Yields: The Hidden Dangers

Investors looking to generate income from their portfolio are well-advised to buy dividend paying stocks to generate income higher than would otherwise be available from certificates of deposit or savings accounts.

While a high yield is an indication of a high dividend, the income-seeking investor must be wary of buying the highest dividend yields in the market without doing further research into the solvency and profitability of the company. Many of the highest dividend yielding stocks are in essence undergoing liquidation by paying out cash to shareholders and are usually in some kind of financial trouble.

The situation was best described in a book by Seth Klarman, the Boston-based value investor and founder of the Baupost Group. In his book, Margin of Safety, Klarman describes the pursuit of high dividend yields in a short section on The Art of Business Valuation.

Klarman says, “Why is my discussion of dividend yield so short? Although at one time a measure of a business's prosperity, it has become a relic: stocks should simply not be bought on the basis of their dividend yield. Too often struggling companies sport high dividend yields, not because the dividends have been increased, but because the share prices have fallen. Fearing that the stock price will drop further if the dividend is cut, managements maintain the payout, weakening the company even more. Investors buying such stocks for their ostensibly high yields may not be receiving good value. On the contrary, they may be the victims of a pathetic manipulation. The high dividend paid by such companies is not a return on invested capital but rather a return of capital that represents the liquidation of the underlying business. This manipulation was widely used by money-center banks through most of the 1980s and had the (desired) effect of propping up their share prices.”

So what are investors to do? I would recommend narrowing one’s search to companies that have positive earnings, positive cash flows and a PE ratio below the industry average. In addition, potential high dividend and sustainable dividend players generate lots of cash per share, and generally have a very strong balance sheet, with either a lot of cash on hand or for certain businesses with a current ratio well above the industry average. Companies with large sustainable dividends also usually do not have large growth and capital expenditure ambitions but rather generate unexciting returns on equity, thereby freeing cash to be returned to shareholders.

It makes perfectly logic sense: a business that is losing money on a cash basis cannot sustain a high dividend indefinitely, thereby creating a risk for the investor who is relying on such excess cash flows to provide for the payment of dividends.