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Switching to Dividend Stocks? Know the Risk!
Posted by: Gordon Pape (IP Logged)
Date: December 8, 2012 09:46PM

We are joined this week by contributing editor Tom Slee who is concerned about the growing tendency of fixed-income investors to switch into dividend stocks. They may offer higher yields but there are potential pitfalls, he warns. Tom managed millions of dollars of pension money during his career and is an expert on fixed-income securities. Here is his report. Tom Slee writes:

Four years ago, Lehman Brothers collapsed and interest rates plunged. The Federal Reserve slashed its benchmark overnight rate from 5.75% to almost zero in a desperate effort to repair the damage. It has been stranded there ever since.

Record low yields, even negative ones, have become a way of life, so much so that Fed Chairman Ben Bernanke apologized to fixed-income investors for the hardship he has caused. Moreover, there is no relief in sight. All of the central banks are committed to keeping a lid on rates indefinitely in order to spur the recovery.

It's a bleak prospect, especially for defensive fixed-income investors who are being steadily pinched out of the bond market. They have been forced to look elsewhere for more income and incur additional risk, sometimes without realizing it. For instance, some of these investors are turning to the stock market. It's a move that seems to make a lot of sense. The transfer is easy and some stocks are offering relatively attractive yields. Nothing could be simpler, a straight trade, one type of income for another.

Not so! The switch involves a major change in asset allocation. As one commentator pointed out, stocks sure as heck are not bonds. To which I would add dividends are a far cry from interest income.

There is another problem. These income investors are jumping into an already overcrowded sector of the market. Dividend paying shares are all the rage. People looking for growth have been battered by the slow recovery and volatile markets. So they too are turning to dividends in order to supplement their return. More than $32 billion has been invested in income equity funds since January. Here in Canada there were a lot of defensive investors left stranded when their income trusts converted to corporations. They are always reaching for stocks offering above average yields.

The result is that all of the safer blue-chip stocks are relatively expensive. The average yield on the S&P 500 companies is now a paltry 2.21%. The S&P/TSX Composite Index yields 3.2% and that is only because a lot of the larger commodity stocks with suspect dividends are severely depressed.

Yet given the dismal outlook for interest rates in 2013, we are likely to see more people making the move from fixed-income securities to equities, many without realizing all the implications. They often receive little or no guidance from their broker or advisor, just a cursory warning about the reduction in quality and a brief mention that the dividends are not guaranteed but probably reliable.

What is rarely, if ever, explained is the stock market's totally different atmosphere. The investor is trading a quiet backwater (fixed-income) for a rumour mill that is always in flux (the stock market). You need a different temperament. There is no "quiet enjoyment". Money in the stock market for whatever reason is always in play. So here are a few things I think that you should consider before selling fixed-income securities and replacing them with dividend-paying common shares.

First and perhaps most important, the so-called yield published alongside a stock is just an annualized return based on the last dividend declared. That is all we know. The next payment may be different and this is especially true with many European companies that trade as ADRs in New York, They tie their dividends to earnings so they vary annually. Hopefully the dividend will be larger but there's also a chance it could be less, depending on the company and how well it is doing.

Major Canadian and U.S. corporations tend to maintain fairly uniform distributions but even they can be a question mark under certain conditions. If a dividend payment is omitted for any reason, we have lost the income. Most fixed-income investors are aware of this but they are often surprised by the on-going rumours and speculation about whether a company's distributions are safe. This chatter causes constant concern, especially if you depend on the income.

There is also the stock price volatility to contend with. Conventional wisdom is that dividend paying stocks are more stable than the general market. This is not always the case. When a company pays a generous dividend, especially if it results in a high earnings payout ratio, analysts keep commenting on the chances of a reduction in distributions. Then if earnings are at all disappointing there is an immediate assumption that the dividend is in jeopardy regardless of whether management is reassuring.

We saw this recently in the case of Atlantic Power (TSX: ATP) (AP) and also with Just Energy (JE). Both companies pay generous dividends and reported respectable results, but they were slightly below expectations. The alarm spread and without core institutional support in a weak market both income stocks plummeted.

Had these companies paid little or no dividends their earnings would have gone unnoticed. Instead there was a flurry of media attention and fixed-income investors who held Atlantic and Just Energy were extremely worried about the stocks heading south. Market volatility was a new experience. Over the years, the bonds in these same investors' portfolios had almost certainly risen and fallen in value but these fluctuations were out of sight, not quoted daily or exposed to media coverage.

Fixed-income investors with dividend-paying stocks are also vulnerable to the vagaries of business decisions. With bonds you are almost certainly protected by covenants designed to guarantee interest payments as well as the eventual principal repayment. These are never up for discussion. When it comes to dividends, though, the directors have a free hand. They can suddenly reduce or omit the quarterly payments without notice and just keep the money or use it elsewhere. If that happens, your dividend has been lost, there is no recourse.

To give you a couple of examples, Pfizer, a Standard & Poor's "Dividend Aristocrat", cut its distributions in half in 2009 so that it could buy Wyeth for US$68 billion and extend the life of its drug portfolio. Shareholders became a secondary consideration.

BB&T Corporation had raised its dividend for 37 years and was paying a well protected $1.88 as well as buying back stock in 2008. Management suddenly issued a slew of new stock at a much reduced price during the downturn and slashed the dividend by 68%. Analysts thought that it was a smart move. Investors relying on their dividends probably had a different take. They now had less income and diluted stock as well. No amount of analysis and historical dividend history can protect you from this sort of executive decision.

There is another crosscurrent to consider when you are buying dividend stocks in anticipation of increased distributions. Deep down, most CEOs are reluctant to part with their cash, even in good times. They claim that dividend payments limit their opportunities for expansion. In fact, studies show that meaningful distributions merely reduce the cash available and force managers to focus on their best prospects. The "Dividend Aristocrats", a group of 51 companies that have increased their dividend payouts for at least 25 years, include some of the most successful companies of the last century.

Keep in mind too that a lot of shareholders are quite content with low dividends. They are looking for growth rather than current income. North American corporations have been awash in cash for years. The argument is that managers will have this money available when conditions improve. The cash positions keep growing but there has been little outcry, no suggestion that at least some of it should be paid to shareholders. CEOs have no need for all that liquidity. Future expansion could be easily financed with the huge amounts of cheap funding available for this purpose.

All that having been said, I am a firm believer in dividend paying stocks as long as you are aware of the risks. Or to put it another way, buy when the price provides an acceptable risk/return relationship. In the U.S., where more statistics are available, dividends have contributed about 40% of the stock market's annualized return since 1936. Over that time, the market has grown an average of 10.2% a year. Capital gains accounted for 6.2% and the remainder was the result of dividends. Remember, this period includes the years when growth was the name of the game. Yields were low. Companies that distributed earnings to their shareholders were regarded as unexciting.

The key, I think, is to identify companies that are genuinely concerned about their shareholders. Look for a pattern of distributions related to earnings coupled with guidance as to future payout ratios. Make sure that the company has substantial earned surplus and is able to meet its current distributions even if there is an unexpected downturn in profits or we suddenly have another financial collapse on our hands.

Enbridge is a good case in point. The company has paid dividends for almost 60 years and increased them every year since 1996. At present, the company pays $1.13 per share and has publicly targeted a 60% - 70% payout ratio of earnings, which are expected to reach $1.60 a share this year and $1.85 in 2013. This is why Enbridge is a core recommendation of the Internet Wealth Builder.

The fiscal cliff

Turning to an entirely different subject, the so-called fiscal cliff, I think that we should be careful to discount any real benefits if American politicians come to an agreement. The media has hyped this self-created crisis into a make or break event for the economy. But is it? Certainly there will be repercussions if the tax cuts are allowed to expire but extending them solves nothing. We are left with the status quo. Nobody is discussing a new, more enlightened plan to jump-start the spluttering economy.

Avoiding the cliff could be a non-event. As Roger Aliaga-Diaz, senior economist at Vanguard, has pointed out, the fiscal cliff barely registers in the most recent Federal Reserve Bank's Survey of Professional Forecasters. Moreover, Chicago's Options Volatility Index, the infamous "fear index", has remained subdued. Professional investors are surprisingly unconcerned about the mess in Washington.

My feeling, therefore, is that we should not regard a deal to maintain the tax cuts and rationalize spending reductions as a turning point. The structural problems will remain, whatever happens. Any resulting surge in the stock market may be short-lived.

Stocks Discussed: AP, JE,
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