Are Dividend Stocks Really Safe?

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

You sure about that, bud? Many people buy dividends stocks thinking they're safe. But is this really the case?

Many people today like to invest in higher yielding dividend stocks. In this series, I explain the reasons why I'm not a fan of this approach.

In ourlast installment, I explained why companies on a path to high growth should not pay dividends, as doing so actually hurts the investor. If you follow the dividend investing philosophy, you would unfairly leave out such companies from your portfolio, robbing yourself of potentially high returns.

In this installment, I will argue against one of the popular arguments in favour of dividend investing: This notion that dividend stocks are safer.

Why Some People Think Dividend Stocks Are Safer

Where did people get the idea that dividend stocks are safer? Perhaps they read one of many other blogs that subscribe to the dividend investing philosophy. Perhaps they heard it from a financial advisor. Usually, blogs and financial advisors put forward the following argument.

Let's say XYZ stock trades at $10 a share, and pays 40 cents a year in dividends. That's a dividend yield of 4% a year. Next year, the stock declines by 20% to $8 a share, but maintains the same 40 cents in dividends that year. Then, the yield is 0.2/8 = 0.05, or 5%.

In other words, as stock prices go down, the dividend yield goes up. This is true as long as the company keeps paying the same dividend.

When this happens, the thinking goes, other dividend investors will look at the high yield, and buy more of the stock. This will ensure that stocks don't go below a certain price, as yields will become unbelievably attractive below a certain amount.

That's a nice idea. But does it hold in practice?

Examples That Defy This Theory

I would like you to look up three stocks - Enerplus, Chorus Aviation, and Just Energy. In particular, look up their 5 year price history. If you don't know how, go to Google Financeand type in the companies' names.

The 'D's at the bottom of the google finance chart indicate dividend payments. Do you notice a common theme?

All of these companies are, or had been 'dividend stocks'. Below are the stock prices and the dividend yields of the 3 respective companies.

If you're a dividend investor who had stumbled on these companies two years ago, you would have wondered why such opportunities existed. The yields looked just too attractive to pass on.

Indeed, many people did invest on this basis, just like this guy.

As we discussed, this should have lifted stock prices as fellow dividend investors jumped in. However, the stock kept sliding. How come?

Yields Going Higher? Uh-Oh

The answer is simple. Anyone who could actually understand financial statements came to realize that the dividends were unsustainable. So while the average Joes bought, the big money guys sold, and even shorted (i.e. bet against) the stocks.

The stock prices of each of these companies went down and down, until one day, each of the companies came out with their own announcements: they decided to cut dividends.

Enerplus cut their dividends by 50%, to $1.08 a year. If you had bought Enerplus shares at $27.06 a share expecting 8% yield forever, you would have suddeny found yourself holding something that yielded 4% relative to when you bought them. Similar fates awaited for investors in Chorus Aviation and Just Energy.

Sell When Yields Are High?

To be fair, some dividend investors know this. That's why they caution against buying stocks with very high yields, as high yields tend to signal a high likelihood of a dividend cut.

But this prescription raises troubling questions. Let's say you bought a stock that yields 5% - a reasonable yield in your mind. A year later, the stock tanks, and now yields 8%. Suddenly, it's a high yielding stock. Are you now supposed to sell?

If you don't think this can happen, just take a look at Torstar Corporation. In 2010, the stock used to yield just 3.6%. Today, after the stock price fell some 40%, it yields nearly 9%.

Dividend Investing Leads To Value Investing?

I can cite numerous other instances of stocks cutting their dividends, and taking their stock prices down with them (e.g. Pengrowth, NAL Energy, Bonavista, Wajax, and more). These examples show that you should't invest in dividend stocks without first analyzing the companies' ability to pay dividends.

But this proves to be a slippery slope for the self-proclaimed dividend investor. As the focus of the attention shifts from dividends paid today, to the companies' ability to pay dividends, the investor will ask questions such as "How long can this company remain profitable?", "Will the company increase its earnings in the future, so as to be able to pay higher dividends?".

Such questions belong to the value investing philosophy. In other words, the quest to find stocks that will yield healthy returns, may end up leading the investor to abandon dividend investing in favour of value investing.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.