A Warning Sign on High-Dividend Stocks

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Published : December 03rd, 2012
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Category : Market Analysis

 

 

 

 

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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Vedran Vuk graduated with a BBA in Economics from Loyola University of New Orleans. Currently, he is pursuing a M.S. in Finance at Johns Hopkins University. He also spent time on a PhD. Economics program. His publications include academic journal articles, book chapter contributions, newspaper columns, and online articles. Prior to Casey Research, he worked in think tanks, government affairs, and corporate governance. Utilizing his experiences with academics, Washington politics, and financial knowledge, Vedran’s analysis often seeks to find the mid-point between these different areas.
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