Dear Mr. Market:

With interest rates at rock bottom levels many investors have gravitated to dividend yielding stocks over the last several years. Money markets, certificates of deposit and bonds simply are not delivering the rates that investors are looking for or have come to expect. It has left investors looking for other options to generate the income that they are counting on but what are the long-term ramifications? Are investors chasing yields with the risk of digging themselves into a deeper hole? What should investors look for and how can they manage their portfolios effectively?

It doesn’t take much effort to find a laundry list of stocks with very attractive yields. In fact if you simply run a screener on Google it will return a list of nearly 100 stocks that offer a yield of 10% or more! With the stock market continuing its upward trend investors have been moving to these stocks chasing the yields with little attention being paid to the underlying stock and the associated risks.

Before we jump into specific companies and industries let’s make sure we are all on the same page and understand what dividends are.

Definition of Dividend:  A distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield.  

As we mentioned before the yields offered by many companies has been attracting investors for several years as we have been in a low interest rate environment. Investors have been searching for attractive yields as they look to replace the income once generated by the fixed income portion of their portfolio. Typically it is thought that if a stock pays a dividend it is a mature and stable company and investors can count on receiving their stream of payments. The issue is that many investors are now ‘chasing yields’ and simply looking at the dividend that is issues and not taking into consideration the overall strength of the company itself. Here are some factors that need to be considered and monitored with any dividend yielding stock:

• Dividend cut – ideally investors should look for companies that have a track record of increasing their dividends and not cutting them. If a stock announces that it will be cutting its dividend this is a warning sign and should be taken seriously – time to move on and find another option.
• Rapidly increasing Dividend Ratio – Just like the saying “if it seems to good to be true it probably is”. If a company is paying the majority of its earnings out through dividends, how is that company expected to continue to grow and survive long-term?
• Management – If there is a significant change in leadership and the company is moving in a new direction it is time to pay attention. Not only could this have an impact on dividends but more importantly on the price of the stock. Remember what happened with GE when Jack Welch stepped down? Over the last 10 years GE stock has posted a -20% return!
• Earnings or Revenues decreasing – Every stock will have its periodic struggles. Use this as an opportunity to see if it is a long-term trend or simply a ‘bump in the road’. This is an opportunity to examine why you own the stock and if you should continue to.
• Company Debt – If a company’s debt continues to increase this should be a warning that there could be trouble ahead with dividend payments.

When you take a look at some of the yields that are currently being offered and take into account the current interest rate environment it is easy to realize why investors have been flooding dollars into dividend yielding stocks. Before transitioning your portfolio and becoming a “Yield Hound”, careful and thorough examination needs to be done with each position. If a stock is offering a high yield it could also be a sign about the longevity and overall health of the company’s future.

For example let’s take a look at a stock that offers a very attractive yield and has caught plenty of headlines over the last several years … Annaly Capital (NLY). This stock has been a favorite of dividend-focused investors as it offers a yield of over 10% and is up in price by over 18% in 2014. These are numbers that any investor would welcome in their portfolio! But if we dig a bit deeper the picture is not so appealing! Over the last 12 months the stock is up only .04% and over the last 5 years it is down -32%! The stock is essentially paying out all of its earnings to cover the dividend payment to its shareholders. The company has cut its dividend over the last several years as the stock price has fallen. It is impossible for a company to continue to operate in this fashion. What sense does it make to hold on to a stock that offers an attractive yield while shareholders’ principal continues to decline?

Another stock to look at is AT&T (T). This stock offers a yield of 5.25% and has long been considered a poster child of dividend investing. AT&T has posted impressive returns and for investors that owned it since the market correction of 2008, they have been rewarded but the outlook of this stock has changed substantially. The stock price is slightly negative this year and last year posted a return of 4.7% (S&P was up 32%). The yield is attractive considering where interest rates currently are but the stock is not performing well and analysts expect it to struggle going forward. This is prime example of a quality dividend stock from years ago that simply does not warrant a place in portfolios today.

So where do we go from here….

For investors that are looking to generate income from their portfolio they need to accept the fact that a ‘buy and forget’ type of approach will not work effectively. If an investor wants to invest in individual equities they need to monitor the positions that they own and be aware of any significant changes with the company, management, industry and overall economy. An approach we would encourage is looking at ETF’s that focus on dividend oriented stocks. For example let’s take a quick look at the Vanguard High Yield Dividend ETF (VYM). This exchange-traded fund (ETF) has over 300 stocks in its portfolio, offering broad diversification along with a respectable yield of 3.08%. While this position can certainly not compete with some of the individual stocks that offer yields in excess of 10%, it has posted solid returns and diversifies a portfolio bringing down the overall risk.

We encourage all investors to consider how changes to their portfolio fit into their long-term plans. Disciplined investors that remain focused and operate within their financial plan will come out ahead over those that are chasing the ‘hot idea’ (or dividend!) of the day.

The underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in the financial mechanisms and climate.

                                                                                                – Benjamin Graham