Eyeing dividend-paying stocks? Don’t rush to pick up the richest yielding names

Published Mon, Oct 23 20232:04 PM EDTUpdated Mon, Oct 23 20232:51 PM EDT

Dividend-paying stocks could offer investors some ballast as their portfolios face price shocks from equities and bonds – but they'll need to resist the siren call of unreasonably high yields. Last week, the 10-year Treasury yield surpassed the key 5% level for first time since 2007. Bond yields move inversely to their prices. Investors not only saw losses on the fixed income side of their portfolio, but equities also suffered as the S & P 500 shed 2.4% during the week. Today's higher interest rate environment drives home the reason why investors should scrutinize stocks offering tempting double-digit yields. This is especially the case as sectors known for their income-generating capabilities, like utilities and real estate, are now very cheap. Utilities are off 18% in 2023, while real estate is down 11%. "With the way rates have moved in this cycle, from ultra-low to a very fast-paced Fed that has now led to the 10-year getting close to the 5% level, there are some dislocations that dividend investors have to be aware of," said Charlie Gaffney, managing director at Morgan Stanley Investment Management. "As a result, you have to be more selective, more aware of the balance sheet structure, of refinancing costs that could come up in the near to intermediate term that could be factors in how these companies act," added Gaffney, who is also portfolio manager of the Eaton Vance Dividend Builder Fund (EIUTX) . Digging beneath the surface Multiple factors may contribute to a stock touting high dividend yields at first blush. For instance, a company with a sharp decline in share price and a drop off in growth or earnings may initially show a higher yield in the short term. However, if the company ends up in trouble and needs to trim costs to stay afloat, that dividend may be the first major expense line to be cut, warned Jamie Ebersole, certified financial planner and founder of Ebersole Financial. Special situation dividends are another scenario that can result in higher payments to investors. These are one-off events that can stem from an asset sale or a situation in which a company is sufficiently flush with cash that it can be given back to shareholders in a one-time distribution. "I like special situation dividends, but just because companies announce them doesn't mean that they're solid companies," said Kim Abmeyer, certified financial planner and founder of Abmeyer Wealth Management. Investors ought to look for consistent payment and dividend growth over the years, especially a payout that's low and stable, she said, highlighting Costco Wholesale and EOG as two consistent dividend payers. A three-bucket approach Gaffney of Morgan Stanley thinks of dividend investing in three parts. First, there are dividend sustainers – companies that have made steady payments for years, including Merck , Johnson & Johnson and Southern Co . Then there are the dividend growers. "We like to look at those companies that are in the phase of the business cycle where revenues are growing at an above-average rate, but funneled into good margin expansion opportunities," Gaffney said. These companies offer alpha generation on top of the dividend. Finally, there are companies that can initiate a dividend: These can generate significant amounts of free cash beyond capital expenditures and can hold that cash on the balance sheet. Gaffney named Apple as a successful example. Investors who want to hunt dividend payers shouldn't go for the biggest yielders, but instead look for names that are in the second or third quintile among dividend payers, he said. "You will see those [first quintile] stocks generally come with a higher level of risk and not as good of a performance track record," Gaffney said. Sustainable cash flow is another big priority in the search for dividend payers, as well as dividend payout ratios – or the amount of dividends paid compared with the amount of net income. "Real estate investment trusts and business development companies have special rules that require them to pay out 90% or more of their income," Ebersole said. "They tend to have higher yields, but also a smaller margin of error, and if something is going wrong with the underlying asset, it is harder to sustain that dividend payout," he added. Finding fertile ground For investors seeking faithful dividend payers, mutual funds or exchange-traded funds focused on the dividend aristocrats – names that have increased dividends for more than 25 years – can offer a solid starting point, Ebersole said. The ProShares S & P 500 Dividend Aristocrats (NOBL) , for instance, has a total return of -3.5 % year to date. Household names in the fund include Exxon Mobil , Walmart and Aflac . Meanwhile, Vanguard's Dividend Appreciation ETF (VIG) , makes a point of culling the companies paying the richest yields to ensure stability, according to Morningstar's Bryan Armour. VIG looks for companies with 10 years of dividend growth – and boots companies that miss dividend payments. The fund has a total return of 2.5% in 2023. "For many investors, you can get a pretty good dividend play and a good yield through ETFs at a low cost," said Ebersole. "But those who want to do it on your own? Make sure you're diversified and that you understand the dynamics for that particular company."