On the surface, this seems quite sensible. Unfortunately, this advice has led to an over-infatuation with dividend yields. Everyone and their dog is searching for the highest return possible, forgetting that the point of investing in equities is to own small pieces of great companies. The dividend is icing on the cake. (Discover the issues that complicate dividend payouts for investors; read Dividend Facts You May Not Know.)
Sorting The Wheat From The Chaff
Once markets recover, dividend yields will be yesterday's news. In the meantime, it's important for investors to understand why yields are rising and to consider whether this is a good thing. The simple answer: Yields are up because stock prices are down. Investors of all stripes have been hurt in the past 14 months, which has led to irrational decisions based on cash flow. Let's say you're used to your portfolio producing 8% a year in capital appreciation and dividend income combined, and now you feel you need to find a dividend yield of 12% to offset the loss you're likely experiencing in the stock price. Unfortunately, chasing unsustainable returns is a losing battle.
Dividends Cut
Numerous companies are cutting their annual dividend to preserve cash. The most recent is General Electric (NYSE:GE), which announced February 27 that it was cutting its annual payment to shareholders by 68% from $1.24 to 40 cents a share, saving the company $9 billion annually. Overnight, this dropped the effective yield from 15% to 5%. How do you think Berkshire Hathaway (NYSE:BRK.A) feels about the 10% interest it's getting on its preferred shares? Buffett's no fool.
For the rest of us, before we bite into a juicy yield, we might want to consider how sustainable a company's dividend really is. If General Electric can hack away, what's to stop the everyday, garden-variety company from doing the same? Nothing. Standard & Poor's estimates the S&P 500 will see dividends cut by 13% in 2009, the worst drop in six decades. Knowing this, what makes you think your investment won't do the same? (The economy has a large impact on the market. Know how to interpret the most important reports; read our Economic Indicators tutorial.)
It's Amazing What People Will Do
Despite evidence that dividend cuts are currently the norm rather than the exception, investors increasingly are becoming mesmerized with double-digit yields. Take the shipping industry, for example. Before the end of 2008, upwards of 15 companies' stocks were yielding close to or more than 20%. These included reader favorites DryShips (Nasdaq:DRYS), Diana Shipping (NYSE:DSX) and Ship Finance International (NYSE:SFL). Several people have asked which is the best investment. The answer? None, when you consider that at least five of those 15 have suspended their dividends (including DryShips and Diana) in the first two months of this year.
Frankly, even though the Baltic Dry Index (a measure of the cost of sea transport) has rebounded nicely since its low of 663 in December, it's hard to imagine the index holding its current levels around 2000, and that is the only bright spot in an otherwise hopeless situation. Personally, I'd be much more comfortable holding a stock like Buckle (NYSE:BKE) with a 3.5% yield and strong revenue and earnings growth.
Bottom Line
While it's tempting to invest in high-yielding, dividend-paying stocks, remember these yields are unsustainable. I'd worry more about the quality of the company and less about the dividend it pays. Quality usually wins out over quantity.
