Every investor loves a good dividend stock, especially when markets get a little crazy.
Get paid—and generate income during rocky times—is a compelling sales pitch. So are steadiness and predictability, common traits in companies with the wherewithal to share profits with the public.
Rising dividends provide a hedge against inflation and the power of compounding reinvested dividends over time.
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And who doesn’t love reduced volatility, another hallmark of dividend investing?
But investors get so enamored of those pluses that they often let yield obscure stock-specific risk, and a leading stock market research firm says that a stunningly small number of dividend-paying stocks truly represent great investments.
Worse, according to research from New Constructs, a much larger number of the companies making distributions fall into one of three dangerous categories: “fake dividends, false dividends or dividend traps.”
Stock Dividends can improve portfolio returns but not all dividend paying stocks are created equal, say experts.
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Lower average dividend yields create rush to high payouts
A dividend is a payment from a company to its shareholders out of its profits or reserves. From the 1960s until the mid-1990s, the dividend yield of the Standard & Poor’s 500 Index ranged from 3% to just over 6%, and those payouts represented a huge portion of the growth that the stock market was able to deliver.
In the 1960s, dividends contributed about 45% of the gains experienced by the S&P 500, according to data from Morningstar and the Hartford Funds.
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In the 1970s, dividends generated 73% of the total return for the index. In the ‘80s, they accounted for nearly 30 percent of what a buy-and-hold index investor earned.
During the 1990s, as the Internet Bubble was inflating, dividends were de-emphasized. Corporate executives at the time felt that they were better able to deploy their capital by reinvesting it in their businesses rather than returning it to shareholders.
Significant capital appreciation year in and year out caused investors to shift their attention away from dividends.
Until the Dot-com bubble burst.
Coupled with the Great Financial Crisis (GFC) of 2008, the market had a lost decade; the index itself was negative from 2000 through 2009, but its total return was positive—even if it was a paltry average annualized gain of 1.2%—thanks to the earnings provided by dividends.
With those market downturns, investors again focused on fundamentals like price/earnings ratios and dividend yields, and dividend-paying stocks made a comeback. Declining stock prices pumped up yields, and in the middle of the GFC, the average dividend yield for the S&P 500 got back above 3%.
The long-term average dividend yield on the S&P 500 is roughly 1.8%; according to data provided by Standard & Poor’s, though, the current average stands closer to 1.3%, a level it has hovered around for several years.
With those kind of numbers, it’s easy to see why above-average dividend payers draw investors like coworkers to free donuts.
Chasing yields provides sugar high, little substance
Enter New Constructs, which over a three-week period, focused on different aspects of dangerous dividend games, putting “fake dividends, false dividends and dividend traps” into the “Danger Zone” feature it does on “Money Life with Chuck Jaffe.”
New Constructs brings together discounted cash-flow analysis and forensic accounting to evaluate securities on a scale of “most attractive” to “most dangerous.”
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The firm’s stock-picking routinely has been rated by SumZero at or near the top of multiple investment categories, most notably leading consistently in consumer discretionary stocks; SumZero is a buy-side community in which more than 15,000 professional portfolio managers compete for rankings.
“We’ve been hearing a lot in the crazy volatile markets about safer investing, smarter investing, and a lot of people immediately just jump to dividend investing,” said David Trainer, founder and president of New Constructs, in an interview that aired on Money Life on June 2. “They oversimplify it. They think it’s as simple as finding stocks to just pay good dividends. … Not all dividend stocks are made the same.”
That’s borne out by the firm’s research in multiple ways.
New Constructs tracks 3,310 stocks, of which 1,421 pay dividends, and just 45 of those companies – 3% of the dividend-paying universe – get an “attractive” or “very attractive” rating from the firm.
The firm has labeled 12 times that many stocks as fake dividends, false dividends, and dividend traps.
Trainer defined each term and how each situation leads investors astray. New Constructs research included specific examples.
How to spot fake, false dividends
Fake dividends occur when a company is paying a dividend, but its stock is poised for a loss that is “more likely to go down 2, 10, 5 or 20 times what the dividend yield is, which means whatever you think about that dividend yield, you’re going to losing money overall.”
As an example, Trainer cited Digital Realty Trust ( (DLR) ; 2.75% dividend), which has a dividend yield of roughly 2.8% but gets a “very unattractive” rating from New Constructs due to “negative cash flows, negative economic earnings {and an] economic book value around negative 30, 40 bucks a share.
“So we see a lot of downside here in this super-hot stock that people might think is a dividend stock as well. … But this is not a safe dividend stock … {because] the downside risk in the stock dwarfs the dividend.”
Trainer said he has a hard time coming up with a fair value on DLR due to the negative economic book value, but he said the downside risk on the stock is roughly $85 per share, which would be a 50% haircut from current levels.
New Constructs says DLR is one of 37 stocks currently categorized as having a fake dividend.
False dividends occur when a company shows a nice dividend yield, but its cash flows are either negative or insufficient to support the dividend.
Investment analyst Kyle Guske said there are 344 stocks that New Constructs has labeled as having false dividends. He noted that companies—stuck with higher interest rates for several years now—are struggling to “fake it til they make it” by borrowing, which is why he expects firms with poor fundamentals, high debt, and little return on capital to be cutting payouts soon.
As examples, Guske cited AES Corp. (AES; 6.9% dividend), CTO Realty Growth ( (CTO) ; 8.3% dividend) and Edison International ( (EIX) ; 5.9% dividend), making the case that their numbers suggest dividend cuts are inevitable.
“As soon as that dividend gets cut,” Guske said in a June 9 interview on Money Life, “people flee looking for other yield. It could create some sort of spiral there, with [false dividend] stocks dropping while people look for higher yields. … Once that dividend gets cut or if they are unable to maintain it, it could create a cascading effect.”
Dividend traps: like “value traps, but worse”
Dividend-trap stocks look good on the outside; they can make their payouts without any shenanigans, and a dividend cut isn’t remotely on the horizon.
The problem is that their stock prices are over the moon; with the stock price so high, the yield is low, and that creates the rub.
New Constructs has identified 181 dividend traps, meaning that more than one of every 12 dividend-paying stocks is a trap.
“We think people often get misled when it comes to dividend stocks in general,” Trainer said in an interview on the June 16 episode of Money Life. With a dividend trap, he continued, “if the stock goes down, you are going to lose more money than you make in dividends. That’s the problem in chasing yields.”
He used WD-40 Co. (WDFC) as an example, noting the stock trades near $240 with a dividend near 1.6%, and great cash-flow.
“But the stock price is really expensive,” Trainer said, noting that the 3:1 ratio of price to economic book value means the market is already expecting the company’s profits to improve 300%.
New Constructs gives the stock an “unattractive” rating, noting that the “no-growth value” of the stock is $80 per share, a two-thirds haircut. Where dividend investors like “getting paid to wait” for a stock to come around, Trainer said that it would take decades for the 1.5% yield to make up for the losses he sees looming for the stock.
“Investors deserve both a good dividend and a good stock,” Trainer said. “They shouldn’t be forced to choose between the two. The challenge is that it’s hard to find both; there’s not many [great dividend stocks] out there.”