Can you recognize 'dividend traps'?

A Dividend Aristocrat recently fell from grace. What were the warning signs, and are your high-yield investments giving off similar signals?

By StreetAuthority Jun 14, 2013 6:04PM
Burning money © Lumina Imaging, Digital Vision, Getty ImagesBy David Goodboy

Everything was looking great with my new investment.

The stock had been steadily climbing higher since my purchase in early January. This company was among the original members of the S&P 500 and once ranked among the Dividend Aristocrats. Members of this exclusive list have raised their dividends annually for 25 consecutive years. Talk about a vote of confidence!

However, the company was dropped from that list recently. Not because of an issue with its dividends, but because it no longer had the minimum $3 billion market capitalization to remain a member.

In addition, sales had been slipping over the past several years. Counterbalancing the bad news, the company was still creating decent cash flow, producing solid returns on invested capital and trading at relatively low price.

Entering the position at an average price of $10.50 and watching it grow nearly 60% to around $16 convinced me that I had made the right decision, despite the negative undertones on the company.

Then reality struck.

On April 30, the company announced a 57% decrease in first-quarter earnings and a 50% dividend slash.

How could have this happened? The company had been increasing its dividends for over a quarter-century -- and as soon as I invest, it decides to do the opposite in a big way.

If you haven't guessed, the stock I'm talking about is Pitney Bowes (PBI).


Pitney Bowes is a good example of what can happen to a high-yielding dividend stock. Even a former Dividend Aristocrat is not immune.
 
To keep from falling into a "dividend trap," it's critical investors study the fundamentals of the company, not just the performance of the shares. Look for steadily decreasing sales, falling earnings and issues with competitors making inroads into the business. Not to mention high debt levels.

In addition, common sense also needs to be applied. For example, Pitney Bowes' core business of stamp machines and mailing equipment has been decreasing over the years due to the growing popularity of email over traditional mail. In retrospect, it made sense that the company would slash its dividend.

Pitney Bowes is far from alone with its decision to slash dividends. Over the years, venerable companies such as Eastman Kodak (EKDKQ), J.C. Penney (JCP), Citigroup (C) and Bank of America (BAC) have all fallen from their former status as dividend-paying machines.

Similar dangers face these high-paying firms.

Windstream (WIN)
This telecommunications company is the highest-yielding stock in the S&P 500. It boasts a yield of nearly 12% and a market cap of close to $5 billion.

However, the debt-to-equity ratio is nearly 9%, and the quick ratio is 0.32. This indicates the company will not be able to cover its short-term cash burn. Perhaps most importantly, the dividend payout ratio is 357%! This means it's paying out much more in dividends than it's bringing in in earnings.

In the technical picture, the stock just bounced off support at its recent lows below $8, but it remains well below the 50- and 200-day simple moving averages.


BGC Partners (BGCP)
Shares of this high-yielding wholesale brokerage company, which deals in the financial and real estate markets, have soared more than 50% this year and currently yield nearly 8% annually.


On the surface, the company looks good -- with revenue growth beating the industry average and net operating cash flow rising more than 150% from the same quarter last year.

However, deeper digging reveals an extremely low profit margin of 9.2% and a net profit margin of 1.57%, which is sharply below the industry average. Most telling is the dividend payout ratio, which stands at more than 380%, meaning BGC can't maintain the current dividend without raising more capital.

Risks to consider: Dangerous dividend stocks can continue to pay dividends and perform solidly much longer than their fundamentals would indicate. The primary risk in culling your portfolio of questionable dividend payers is missing out on future yields.

Action to take: Check your portfolio for high-dividend yielders and dig into their fundamentals. Ask yourself if the fundamentals support the dividend payments. If not, it may be time to jettison those stocks for others with less yield but better prospects.

More From StreetAuthority
David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.


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2Comments
Jun 15, 2013 1:50PM
Jun 14, 2013 7:40PM
avatar

Been there done that!

 

Now it's just Guns, Precious Metals and hopefully high quality stocks paying dividends, but with an eye towards the future. There are things gonna happen in the future that will most likely happen....hopefully.

 

Life's a gamble!

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