The Problem with High Dividend Yields

Posted on April 17, 2013 by David Laidlaw

On February 14th, Centurylink Inc (CTL) cut its dividend by 26% and the stock fell 23%. At the time, the stock was yielding 7%. After cutting its dividend, it will yield 6% going forward (lower dividend, lower stock price). The stock has recovered some of the loss since, but is still well off the February 13th close. Stocks are inherently volatile and any stock can fall by 23% in one day, but this example illustrates the need to look beyond the yield of a stock.

CTL’s revenue is not growing and the company has more debt than equity. It has been acquiring companies rapidly over the last few years to make up for the lack of growth in its legacy local and long distance phone service. There is not much that is appealing about the company except for its dividend and once that is gone, the stock falls as evidenced by its trading last month.

All high-dividend paying stocks do not fall 23%, but dividends are not a magical elixir to guarantee equity returns. The appeal of getting all of one’s cash needs from dividends is that this strategy has the potential to shield an investor’s cash flow

from short-term volatility. For example, if an individual has a $1 million portfolio and wants $40,000 in cash, then he or she can seek out stocks paying over 4%. If the hypothetical portfolio falls to $800,000, it could still generate the $40,000 of income if no dividends are cut. One could then hold his or her equity positions until the market bounces back.

The problem with this approach happens when an investor reaches for yield well above the market rate. This strategy produces a portfolio full of poorly positioned companies (e.g. CTL) or high concentrations in certain sectors like financials or utilities. A financial heavy portfolio would have been crushed at the end of 2008. Citigroup’s stock price has still not recovered and it’s now paying a nominal $0.01 dividend. In other words, this portfolio can face the double whammy of failing to recover and the dividends being cut. Four percent is two times the current yield of the S&P 500. A current portfolio of S&P companies yielding over 4% would be mostly utilities and tobacco companies all trading at historically high P/E ratios. When interest rates increase, these companies, currently being bid up due to their yield, will fall almost as if they’re long-term bonds.

For taxable accounts, increased dividends can mean less reliance on capital gains, and thus lower capital gains taxes. However the overall tax bill is most likely increased. For most taxpayers, dividends are taxed at 15% just like capital gains, but the effective tax rate is lower for gains. For example, the $1 million portfolio needs $40,000 in cash, or 4%. If this all comes in the form of dividends, one owes 15% on the $40,000 or $6,000. Or, it is also possible to get half from dividends (a 2% yield) and the other half from selling stock. But the $20,000 from stock sales are not going to be 100% gain. If it’s a 50% gain on average, the investor will have total gains of $10,000. Therefore, the total tax bill will be 15% of $20,000 and 15% of $10,000, or $4,500.

We believe in a balanced approach to generating cash needs – realizing gains and relying on dividends. This gives a strong combination of good companies and cash flow that is partially shielded from short-term market fluctuations. Dividends are a good indication of corporate management that keeps its real bosses (shareholders) in mind since it’s a direct return of the company’s capital to shareholders. And while companies in trouble will cut their dividends, strong companies can increase them. Qualcomm Inc. (QCOM) increased its dividend 40% on March 5th and went from a 1.5% yield to a 2.1% yield. Cisco increased its dividend 21% on March 28th and now yields 3.2%.

Over the long-term, this balanced approach results in a strong and diversified portfolio.