As the dividend goes, so too goes the share price.
For this reason, I’m attracted to quality dividend-growth stocks. Look no further than dividend-growth powerhouses ExxonMobil (NYSE: XOM), Altria (NYSE: MO), Johnson & Johnson (NYSE: JNJ),and Procter & Gamble (NYSE: PG). Every year this quartet increases its annual dividend, and over time their share prices faithfully keep pace with the higher payout.
Dividend increases are a simple yet powerful means to create investor wealth. I know of no better strategy for individual investors to employ to ensure their wealth rises over the years.
Unfortunately, it works the other way, too: Dividend cuts frequently destroy wealth. Indeed, data compiled by Ned Davis Research show that from 1972 to 2012, companies that cut or eliminated dividends were the worst-performing group of stocks. Small, medium, or large, no company is immune.
The devastation inflicted by a dividend cut can be immediate.
When telecom CenturyLink (NYSE: CTL) sliced its quarterly dividend 25% last year, investors immediately shaved 18% off CenturyLink’s value. When Boardwalk Pipeline Partners (NYSE: BWP) slashed its quarterly distribution to $0.10 per unit from $0.53 per unit in February, investors immediately slashed Boardwalk’s unit price to $13 from $25.
But even the whiff of an impending dividend cut can send a stock into a downward spiral.
Legions of investors were drawn to years of dividend growth from JC Penney (NYSE: JCP), Avon Products (NYSE: AVP), Citigroup (NYSE: C), and Exelon Corp. (NYSE: EXC). But then cracks began to appear in their foundations. Smart income investors heeded what they saw and sold. They avoided the 50% to 75% downdrafts.
Many naïve income investors, on the other hand, took a contrary tact. They bought into a falling share price, having been seduced by the rising yield. After all, these companies had an established history of dividend growth; surely the growth would continue. The lower price was a buying opportunity, they reasoned.
I, as much as anyone, vet companies with falling share prices and rising yields. But value is often elusive. Many times, a falling share price is justified: Negative trends that develop in the financial statements frequently lead to an impending dividend cut, or an outright elimination.
As a general rule, the higher the yield, the greater the risk. But even low and moderate yields can prove too good to be true if fundamentals are weakening.
Fortunately, separating the wheat from the chaff isn’t terribly complicated. You just need to know where to look. To get pointed in the right direction, I recommend investors start by asking (and answering) three important questions:
- Does the company have, and generate, enough cash?
- Does the company carry too much debt?
- Is the dividend-payout ratio sustainable?
If you’re unsure how to answer these questions, you can find yourself buying a future dividend-cutter or eliminator.
The good news is we can help. We’ve produced a special report at High Yield Wealth that shows you what financial markers to vet to ensure your dividend stream continues to flow freely. What’s more, we’ve even done all the heavy lifting. We’ve also produced a table of the 101 riskiest dividends based on these markers we’ve vetted.