Tags: Defense Investing, Dividend, Dividend Yield, Dividends, Investing Strategy, U.S. Economy

Defensive Investing: Seven Signs Your Dividend is in Trouble

[Editor's Note: Money Morning readers have been clamoring for a story on dividend-investing strategies. In this latest installment in our ongoing "Defensive Investing" series, we deliver. Former merchant banker Martin Hutchinson, an expert on income investments, details the heightened importance of high-yielding dividend stocks - and outlines the seven signs that your dividend may be in trouble.]

By , Money Morning •

Both the U.S. stock market and the U.S. economy are navigating rough waters right now.

U.S. employment, which had appeared to be moving into rapid expansion, suffered a setback in May, with the economy creating only 41,000 jobs. Meanwhile, the stock market - even with the recent rebound that brought it back to the 10,000 level - remains more than 15% below its cyclical high.

That's been the uncomfortable pattern: One economic report points toward a continued U.S. recovery; the next one points toward recession. Sometimes the contradictory research is separated by a single day, other times they are just hours apart. The resultant uncertainty is whipsawing U.S. stock prices - and is leaving investors feeling shaky.

Fortunately, there is a ready remedy, not to mention a place of refuge, from this kind of grinding uncertainty - high-yielding dividend stocks.

When Dividends Matter

In bull markets, dividends become more or less irrelevant. When the Dow Jones Industrial Average traded above 14,000 in 2007, very few stocks had a dividend yield of more than 5%. Indeed, at the peak of the 1998-2000 bull market, the yield on the stock market as a whole dropped close to 1%. Investors in such periods are seeking the next excitement, which will provide short-term capital gains. In 2000, they were looking for such excitements mostly from tech companies; in 2007 they were looking for excitement mostly from leveraged positions, perhaps through private equity or hedge funds. Either way, dividend yields played little role.

As we saw after 2000, again in 2008, and are to some extent seeing today, chasing after short-term gains is not the way to maximize investment returns. While you can do well during the bull phase - that is, when all shares of a particular type are rising - the losses that you'll suffer when the stock market turns will be horrendous.

Indeed, those losses can damage your portfolio enough that it never recovers.

On the other hand, dividend-paying stocks provide better long-term returns in all but the most extreme bull markets. If the market is flat or gently rising, the dividends themselves provide a nice yield and possibly capital gains that easily outpace any modest capital gains generated by the broad market. If the markets decline, the dividends provide an excellent protection against outperforming the market on the downside.

A tech stock that trades at a high valuation and that pays no dividend can lose essentially all its value, even without going bust. If you want an example, just look at telecommunications-equipment-maker JDS Uniphase Corp. (NASDAQ: JDSU).

Defensive Investing JDS is still a billion-dollar company - its fiscal 2009 sales were nearly $1.3 billion and its current market cap is roughly $2.5 billion - but the firm has still seen its share price plummet from $1,100 a share to the single-digits after the tech-stock bubble burst in 2000.

If a company is solid enough to pay a good dividend - and can demonstrate that it has the wherewithal to continue to do so - a share-price decline of that magnitude is very unlikely. Build yourself a diversified portfolio of similarly solid dividend payers and you'll be exceptionally well protected.

The Seven Signs of Trouble

The one difficulty with income investing is figuring out whether the dividend is solid. You need to be very confident of the company itself and of its long-term prospects before investing. Some warning signals that a dividend may be in danger include the following:

  • A "payout ratio" greater than 100%: If a company is paying out more in dividends than it is likely to earn, a dividend cut is almost certainly in the offing. Avoid dividend stocks with high price-earnings (P/E) ratios, and especially companies that are either making losses, or that are expected to.
  • "Extraordinary items" in last year's income: If the company divested a subsidiary, or had an exceptional year, it may have paid a special dividend to celebrate. That special dividend is unlikely to be repeated.
  • Highly cyclical industry in credit crunch or downturn: Towards an end of an economic cycle or apex of a market upswing, cyclical companies often have so much cash that they don't know what to do with it all. If the company you own shares in opts to make an acquisition at pricey, market-top prices, consider yourself unlucky. On the other hand, if the company has a savvy, shareholder friendly management team, the company will pay out some of that cash in the form of a big dividend, consider yourself to be on the "lucky" side of the shareholder ledger. But just make sure to remember that the payout isn't likely to be repeated once the formerly bullish upswing reverses course and heads lower.
  • The loss of patent protection: If a pharmaceutical company has been highly reliant on revenue from a particular "blockbuster" drug, and that blockbuster comes off patent next year, the dividend is likely to be cut as earnings will decline. Some companies in other, non-pharmaceutical sectors have concessions to operate in important markets that may produce a similar effect.
  • Political pressure on the company's business sector: BP PLC (NYSE: BP) has a very nice dividend yield right now - in the neighborhood of 11%. Even so, BP's shares should be avoided until we're sure that the Gulf oil spill is sorted out, because the Obama administration is trying to strong-arm BP into eliminating its dividend in order to make sure it has enough cash to pay for the cleanup. Just yesterday (Monday), in fact, the stock sold off an additional 9.7% on fears of that dividend cut. Uncertainty is bad for stocks, and with BP there's more than enough uncertainty to go around.
  • Big one-time write-offs: Companies will present their earnings with big write-offs hidden as "extraordinary items" and eliminated from earnings comparisons. But beware: Going forward, companies may be more careful about paying out dividends on such "operating" earnings.
  • Unsustainable earnings: Some analysts and trading services are currently recommending Hatteras Financial Corp. (NYSE: HTS), which invests primarily in government-guaranteed mortgages and has a current yield that's better than 16%. However, a close look shows that HTS makes money for one reason - it capitalizes on the steep "yield-curve differential" between short-term and long-term interest rates. In other words, Hatteras Financial borrows short-term money and invests in long-term mortgages. Since even U.S. Federal Reserve Chairman Ben S. Bernanke can't keep short-term rates at their current level - near 0% - forever, the time will come when those benchmark interest rates have to rise. And when that happens, HTS will see its profit potential take a major hit. Indeed, the company may even make losses as the capital value of its mortgages declines. Speculate on HTS by all means, if you want to, but recognize that the juicy yield won't last.

Some Safe Havens to Consider

In my "Permanent Wealth Investor" advisory service, I refer to companies with high-yielding dividends - whose dividends are safe and stable, and whose stock has some upside promise - as "Alpha Bulldogs." To underscore that this analysis isn't just a theoretical exercise, allow me to take a moment and say that - in my "Permanent Wealth" service - I invest primarily in Alpha Bulldogs, a number of which boast yields that are well into the double digits. Our total return has substantially outperformed the market, and I expect that performance to continue.

Allow me to round out our dividend discussion by suggesting a couple of companies whose high dividends look safe:

  • Pepco Holdings Inc. (NYSE: POM), the utility serving the Washington, D.C., area, which has a dividend yield of nearly 7%.
  • CenturyTel Inc. (NYSE: CTL), a telecom company with a dividend yield of 8.5%.
  • Cherokee Inc. (NYSE: CHKE) a clothing-licensing company with a yield of 8.4%

Happy hunting…

[Editor's Note: Money Morning readers are often amazed by Martin Hutchinson's profit-focused instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show us the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

So it's no surprise that Hutchinson has pulled off a string of forecasting successes in the face of the worst financial crisis since the Great Depression - a financial crisis that, not surprisingly, Hutchinson is widely credited for having predicted and warned about well ahead of time.

For those who aren't regular readers, and who might like an additional illustration of Hutchinson's abilities, consider dividends, the icon of the super-conservative investing set, and gold, the safe-haven nest of perpetual inflation hawks.

With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson has managed to combine dividends, gold and growth into a winning, but low-risk formula that has developed eye-popping returns for subscribers.

To take a moment to find out more about the opportunities related to dividends, gold, "Alpha-Bulldog" stocks and The Permanent Wealth Investor, please click here. You'll likely find it time well spent.]

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