Here’s What You Need To Know If You’re Counting On Dividend Income

March 22, 2017

Here’s What You Need To Know If You’re Counting On Dividend Income

  • I’ll analyze the dividend environment by describing the risk reward scenario for dividend income investors.
  • The ‘monthly dividend company’ will still remain so, but you’ll be able to buy it at a 30% off, or even cheaper.
  • Whatever you’re doing, just don’t chase yields as that is the fastest way to lose a lot of money in this market.

Introduction

What dividend investors don’t like is uncertainty, especially uncertainty related to their dividend income. Nevertheless, uncertainty is exactly the feeling many investors have in this environment, not because of the market as the indexes are constantly breaking records, but because there is a certain feeling in the air that things might soon change and nobody knows how the financial world will look afterward.


Figure 1: Mentions of the word ‘uncertainty’ is at record highs. Source: Bloomberg.

This uncertainty comes from the fear that stocks have detached themselves from fundamentals, unclear U.S. political policies, populist question marks in Europe, new political power in China, and the worst enemy of dividends and yields, inflation. Let’s discuss the best way to position yourself in such an environment, and to better understand the risks and rewards, by analyzing one of the most loved dividend stocks.

Potential Threats To Dividend Yielders

The two main risks related to dividend stocks are a dividend cut, and higher market interest rates. Interest rates are on the rise as the FED has been raising them in response to rising inflation. A dividend stock with a 2% yield is much less attractive now with the 10-year U.S. treasury yield at 2.5% than in was back in July of 2016 when the treasury yield was at 1.36%.


Figure 2: 10-year U.S. treasury yield. Source: Bloomberg.

It’s all a matter of risk. The U.S. government is the global lender of last resort which means it has the lowest risk in the world. Any stock is much more risky than the U.S. government and therefore much less attractive when its yield is below what the government offers. The market hasn’t yet gotten it completely as it’s still driven by greed and mindlessness, but it will eventually price in the interest rate increases.

A great example to analyze the risks and rewards for income investors is the dividend income darling of many, Realty Income Corporation (NYSE: O). As interest rates fell, O’s stock price went from $28 at the top the 2007 real estate bubble to the current $59.86, while also reaching a high of $72.3 in August 2016.


Figure 3: Realty Income Corporation’s stock chart from January 2007 onward. Source: Nasdaq.

Going from $28 to $60 is a jump of more than 100% which should imply that both the dividend and earnings also rose by more than 100%. Well, the dividend has in fact risen 52% since 2007, but earnings have gone nowhere as earnings per share in 2007 were $1.16 and currently they are $1.13. As O is an REIT, it pays out its available cash flows and depreciation is what lowers earnings but still, the current dividend yield is just 4.23%. Why do I say just? Well, because if the FED raises interest rates to the planned 3% or even to 4%, 10-year treasury yields will probably be at 4% or 5% and the expected dividend yield from O will probably be around 6% or even 7%. A yield of 6% with the current dividend would imply a stock price for O of $42.16. This is a potential 28.5% decline strictly related to yield factors and simple risk assessment.

On top of the fact that higher yields will increase O’s expected yield, they will also increase O’s interest expenses on its long term debt of $5.8 billion. The current average cost of debt is 3.8% which means that the cost of the $5.8 billion is $220 million or $0.78 per share.


Figure 4: O’s debt structure. Source: O’s Investor Relations.

The 3.8% cost of debt has been reached in an environment where, for the last 8 years, interest rates have been close to zero. If the FED raises its interest rates to 3%, O’s interest cost will probably rise to 6.8% to justify the difference in risk. Such an increase in interest rates would add $174 million to O’s interest expenses and deduct $0.67 from available cash flows. This would lower the dividend from the current $2.4 to $1.73, further increasing the risk for investors.

If general interest rates increase, some of the tenants will be forced to close and the occupancy level will decrease.


Figure 5: O’s occupancy level declined more than 2% in the last recession. Source: O’s Investor Relations.

Conclusion

I don’t have anything against Realty Income, I’m just using it as an example of what can happen to dividend stocks to get investors to understand the risks and rewards of their investments. As in financial markets everything is dynamic and constantly changes, be sure to know what will happen to the dividend of each one of your companies when the following things change:

Higher interest rates:

  • If a company is considered bond like due to its stability in earnings and dividends, its price will be negatively affected by higher interest rates as other investments, like treasuries, will offer similar yields with less risk.
  • It’s essential to look at the debt levels of any company, not just a dividend yielder, as higher interest rates will negatively affect earnings and available cash for dividends. Highly leveraged dividend yielders will be forced to cut dividends. The median rate cut for U.S. REITs was 25% in 2009.

Expected valuations:

  • Alongside higher interest rates, the current extreme valuations and low dividend yields will reverse to the mean bringing asset prices to their fundamental levels. This holds for all asset classes: real estate, bonds, stocks, etc.

What Can You Do?

If you’re a long term dividend yield investor, what you don’t like is to do something, especially as the current strategy has served you very well in the past with consistently higher dividends and asset value appreciation. What you might contemplate is holding a bit on the dividend reinvestments. The three months T-Bill currently offers 0.72%, so it’s a good place to sit and wait for lower asset prices. With such a strategy, you’re happy if stocks and dividends continue to go up while you’ll also be happy if prices decline because you’ll be able to buy stocks on the cheap.

A strong strategy, especially for income investors, is temporal diversification. Temporal diversification implies buying stocks in sectors that are cheap at the moment. You can read more about it here, and about how to assess which sectors or stocks are currently cheap here. Cyclical sectors like food and other commodities are forced to cut their dividends when the price of their merchandise is low. However, low prices soon push out higher cost producers and quickly restore their profitability and dividends.

Just as an example, if Potash Corporation of Saskatchewan Inc. (NYSE: POT) ever returns to paying out dividends like it used to in 2015, the yield on the current price would be 8.83%.


Figure 6: POT was forced to cut its dividend due to low potash prices. Source: POT.

If you’re just thinking about starting with a dividend income investing strategy, the timing couldn’t be worse. The only exception would be if you’re planning to invest fixed monthly amounts because when prices decline, you’ll be able to buy more.

The worst thing you can do is chase yields. Like we discussed in yesterday’s article on retail, many companies offer high dividend yields, but those aren’t backed by healthy fundamentals and sustainable growth.

Keep reading Investiv Daily as I’ll soon dig deeper into the subject of (un)sustainable high dividend yielders.

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