Ah, income, nectar of the gods. At least for people living on their investments. With cash paying less than a percent, CDs not much more, and 10 year Treasuries hovering at 2%, many investors are stalking dividend-paying companies to get the yield on their portfolio up.
I have been an advocate of investing in high quality, high yielding stocks for many years. As a matter of fact, one of my separate accounts strategies “The Dividend Buster Program,” which was launched in January 2011 and focuses on these stocks, not only beat the DJIA, but also beat the popular “Dogs of the Dow” strategy, which is a fine strategy.
But there are risks to chasing yield. Specifically, when dividends are supported by a stream of cash flows that are contracting, the dividend is at risk. Moreover, the causes behind declining cash flow–lagging sales, compressing margins–often catch the eye of equity investors and put downward pressure on the stock. Thus, while the prospect of a fat dividend can be appealing, the combination of a declining dividend and declining stock price often result in a poor total return. Sometimes these are referred to as “dividend traps”–seemingly juicy income stocks that wind up becoming portfolio dogs.
As a case in point consider Vulcan Materials Corp. (VMC), the nation’s largest producer of construction aggregates. Vulcan began 2011 with a $46 stock price and an indicated annual dividend of $1.00 per share or 2.1%. But on October 14, VMC cut the quarterly dividend from $0.25 to $0.01, or 96%. This may have been presaged by a declining stock price that bottomed out on October 4, at about $27 a share as investors were eying a compound annual contraction in cash flow of about 7% over the last five years.
Shares rebounded on the strength of a $4.8 billion Martin Marietta (MLM) bid of about $37 a share in mid-December, but overall, between the dividend cut and price decline, equity investors have done poorly with VMC.
The chart below lists some well-known companies with contracting cash flow. As noted above, the reasons behind the contraction may ultimately place the shares under pressure, and the dividend may also be at risk, undermining the total return to investors.