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A lot of people are pushing high-yield stocks these
days, so it's extra important to differentiate the good from the bad. I'm not
going to cover every single warning sign of high-dividend-paying stocks in
today's article, but I will touch on one of the most overlooked red flags: a
high dividend matched with a weak credit rating. I can already see some of
our longtime readers rolling their eyes here and saying, "We get it: the
higher the return, usually the higher the risk." Of course that's true,
but this simple risk-and-reward trade-off is not what I'm going to discuss
today.
The problem with stocks with high dividends and a
low credit rating is a strategic and theoretic problem. It is not as simple
as the risk-reward relationship.
To start, let's answer this basic question:
"Why should a company pay a dividend?" If your answer is, "To
provide shareholders with a return," you're halfway right, but also
wrong. Companies should pay dividends when they have nothing better to do
with the money. If a company has a great idea for a new project which
could safely make a 20% return on the money invested, the firm should start
that project. You don't want a company paying out its excess cash in the form
of dividends just to appease shareholders searching for yield – that's
short-term thinking. The whole point of investing is to have a company grow
your assets.
Now, companies don't always have blockbuster idea
after blockbuster idea, so it's a good thing that dividends are paid out. You
don't want cash just sitting on the balance sheet doing nothing – or
even worse, getting eaten away by inflation. The money is better in your
hands, if the company has no projects with greater returns than what you
could safely earn on your own.
The problem with companies with low credit ratings
is that they always have a worthwhile place to use the money, i.e.,
paying off the debt. Even if a company doesn't have a project earning 20%
returns, it can save their shareholders 6% or 7% by
paying down the debt early, rather than paying out a dividend.
As a result, if a company pays dividends despite
debt problems, there's a strategic problem with how the company is run. It's
paying shareholders to appease them, rather than fixing the company's debt
and liquidity situation which would benefit the shareholders more so in the
long run. This is more problematic than a simple ratio of two things on a
balance sheet. Paying high dividends while faced with bad credit speaks badly
of the company's strategic planning.
Now, as I said initially, this is a warning sign
– it is not a litmus test. There are circumstances where a company can
have a weak credit rating and a high dividend. For example, if the debt is
relatively new or the company is going through a temporary rough patch, it
might make sense to keep a dividend high and stable. Suppose a company raised
a lot of debt for a takeover. Its credit rating might be suddenly very bad,
but it shouldn't want to change the dividend, as the situation is transitory.
Typically, lowering a dividend sends an extremely negative signal to the
market about the company's long-term prospects. So, paying off the debt by
lowering the dividend might send a signal to the market which does more
damage than good.
Another situation where this might be acceptable is
when a company doesn't foresee any major capital expenditures in the near
future. A bad credit rating only really hurts if you're issuing new debt. If
there's no new debt, then it's not such a big problem. A smooth dividend
might be seen as more attractive than slightly improving the company's credit
when there are no plans for raising capital.
These are just a few exceptions; you really have to get
in the details of the company to make sure that everything is all right. It's
also important to make sure the company has a low payout ratio if it already
has a low credit rating. However, the most important takeaway is that when
you see a stock with a high dividend and a low credit rating, you've spotted
a flag that needs more investigation. This doesn't warrant immediately
dropping the stock, but you definitely need extra due diligence on the pick.
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