Published June 26th, 2015
Dividend investing can be easy. Buying and holding stocks that pay rising dividends year after year is not particularly complicated.
Like any endeavor, practice makes perfect. The 3 avoidable mistakes in this article will help dividend investors to make fewer errors in their investing process.
Chasing High Yield Stocks
High yield stocks are appealing. 4%, 5%, or 6% yields looks so much better than 2% or 3% yields. Often (but not always), high yield stocks offer little in the way of growth potential. The dividend yield on high yield stocks is often the only return investors will see.
High yield stocks have a second weakness. When interest rates rise, high yield stocks will see their values decline more than dividend growth stocks. Dividend growth stocks offer investors both current income and growth potential.
Most high yield stocks only offer current income potential, with weak-at-best growth prospects. When interest rates rise, high yield stocks values decline as their yields become less attractive due to higher interest rates.
When a business has a high yield, it often has a high payout ratio. Stocks with high payout ratios have less money to invest in growth. This typically translates into slower growth – or no growth at all.
Contrast this predicament to a business that invests in growth and pays its shareholders a dividend. Dividend growth stocks are able to invest in future growth and grow their business – and their dividends – over time.
There are exceptions, however. High yield in itself is not bad. There are a select few stocks that are able to maintain a high payout ratio while still delivering solid growth numbers. Philip Morris International (PM) is an example of just such a stock.
Being Tricked By Dividend Growth
Another common error for dividend investors is to be tricked by unsustainable dividend growth.
If a company holds its payout ratio constant, dividends can only grow as fast as earnings. Businesses can show unsustainably high dividend growth by hiking their payout rate. Obviously, a business cannot indefinitely increase its payout ratio.
Imagine two businesses. Each pay $1.00 in dividends-per-share and have $4.00 in earnings-per-share. Both businesses therefore have a payout ratio of 25%.
Over the next 5 years, business 1 is able to double its earnings-per-share to $8.00. The company keeps its payout ratio at 25% and pays a dividend of $2.00 per share.
Business 2 shows no earnings growth over the next 5 years. The company decides to max out its payout rate to 100% pay $4.00 in dividends.
In the example above, business 2 would show a much higher dividend growth rate than business 1. In reality, business 1 is growing much faster than business 2. Over the long-run, business 1’s dividends will far outstrip business 2’s dividends.
Investing in Overvalued Stocks
Investing in overvalued stocks is the biggest mistake dividend investors can make. The more overvalued the stock, the severity of the error in investing.
Unfortunately, high quality stocks are often overvalued. Investors see the safety of a business or the better-than-average growth prospects of a business and bid up the price.
This reduces future returns as investors are paying too much money in the present for future growth. An example of a current high quality business that appears overvalued is Brown-Forman (BF.B).
Brown-Forman is an excellent business. Brown-Forman’s flagship brand is Jack Daniels. Jack Daniels whiskey is enjoyed throughout the world. The liquor business is an excellent example of a slow changing industry. Alcohol production in general is one of the oldest industries. People will very likely continue to drink alcohol – and Jack Daniels. Simply put, Brown-Forman is a low risk business.
This does not mean it is a low-risk investment, however. The company is currently trading at a price-to-earnings ratio over 30. This may be suitable for a business consistently growing earnings-per-share at 15% or 20% a year. Unfortunately, Brown-Forman is not realizing that level of growth.
Over the last decade, Brown-Forman has compounded its earnings-per-share at 8.4% a year. This is a solid and sustainable growth rate for the company – it just does not justify a price-to-earnings ratio of over 30.
When a business has a lofty price-to-earnings ratio, investors are vulnerable to changes in sentiment on the stock. If a bit of bad news comes out about Brown-Forman, the stock could easily correct to a lower price-to-earnings multiple and remain there for years – destroying shareholder value in the process.
Building a dividend growth portfolio is an excellent way to create a growing passive income stream. Avoiding high yield low growth stocks, businesses with unsustainable dividend growth, and overvalued stocks will help to significantly reduce the amount of ‘misses’ in a dividend growth portfolio.