 | | Obsessing over dividends exposes you to this big risk | | |  | | | Brian Tycangco
Editor,
Stansberry Pacific Research | | For some stock investors, dividends are the holy grail. Five percent yield? Great... especially compared to what you can get in a bank account.
But dividends can be a terrible guide. And focusing on 5 percent of the value of your capital - that is, the share price of the stock that's paying you 5 percent - can be like swerving to avoid the squirrel running across the road... right into the path of an oncoming Mac truck.
That's because a company's ability to sustain its dividends depends on several factors: its earnings, its ability to generate enough free cash flow and its level of debt. These factors can change dramatically year over year, quarter over quarter.
And - this is the dangerous part - what happens if the share price drops? Just because a company can continue to pay a dividend doesn't mean it's growing. And that can spell trouble for a share price... trouble that can rapidly erase that 5 percent return from yield. | What to do with your stocks in 2019
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And this mistake could potentially cost you thousands, even hundreds of thousands of dollars. Find out how to know when to sell every stock you own. | Do you buy stocks for income?
Dividends are often compared to the risk-free rate of return - that is, the yield on a government issued fixed-income security, like a bond or treasury. (It's called a risk-free rate because, theoretically, government-issued debt carries no risk of loss. It will be paid no matter what.)
In December 2008, the world's central banks embarked on an unprecedented scale of quantitative easing - the process where they deliberately increased money supply to drive down interest rates. As a result, yields on traditionally safe government bonds have yet to recover to their pre-crisis levels. In the U.S., even with the Federal Reserve hiking rates, the yield on the benchmark 10-year Treasury (at 2.7 percent) is still well below the 4 percent level before the global financial crisis in 2008-2009.
Yields elsewhere are low. In Switzerland, Japan and Germany, yields on many shorter-term treasuries are negative. US$7.9 trillion worth of bonds globally are still yielding negative returns.
This is why more investors are looking to dividend-paying stocks as a source of safe, reliable income. But they're in danger of making the mistake of overlooking the important factors that drive dividends. It's a recipe for disaster.
Your capital could be at risk
For example...
China Mobile (Exchange: New York; ticker: CHL) is China's dominant mobile services provider, with 902 million subscribers. That's three times more subscribers than AT&T (Exchange: New York; ticker: T) and Verizon Wireless (Exchange: New York; ticker: VZ) - combined.
Five years ago, China Mobile's stock price was US$47.85. It was considered a mature, stable business, and it paid out US$2.26 in dividends that year. That was equivalent to a hefty 4.7 percent yield.
Today, the stock is selling for US$52.26. That's a 9.2 percent capital gain.
Including the US$9.67 in total dividends paid over the period, the total return - had you bought shares five years ago - would be 29.4 percent.
But it's important to note that China Mobile's earnings have actually declined by 17 percent over the last five years, from US$5.10 per share in 2012 to US$4.23 in 2017. And as earnings fell, so did the dividend.
Based on last year's dividend payout of US$1.87, someone who purchased China Mobile five years ago expecting a 4.7 percent dividend now has to settle for just 3.9 percent.
What this means is China Mobile's stock had become more expensive over the years. From a price-to-earnings (P/E) ratio of just 9.4 times, China Mobile is now trading for 12.3 times P/E. (The price-to-earnings ratio is a common valuation used to determine the value of the share price relative to its earnings.)
An investor who bought China Mobile stock five years ago would have a respectable five-year return not because the business did well, but because its P/E ratio went up in the face of declining earnings. This is unsustainable. P/E ratios can't go up indefinitely, especially when a company's growth profile doesn't support a higher valuation.
Had China Mobile's P/E stayed the same, the shares would today be worth US$39.76 instead of US$52.26. Investors would have lost 17 percent of their capital, while pocketing 20.2 percent from dividends - for a total return of just 3.2 percent.
This means investors looking to buy China Mobile for its yield have had to rely on the shares becoming more expensive (on a valuation basis) in order to realise higher returns. That may work if the yield's difference to the risk-free rate is large enough. But the more China Mobile cuts its dividends, the less investors will be willing to own it. |  Retire Rich on One Stock!
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As I said, China Mobile's earnings have declined in four out of the last five years. The only reason is has delivered better than U.S. Treasury returns is because its P/E ratio has risen and made up the difference - making its valuation more expensive.
That doesn't mean China Mobile can't continue rising, and its P/E ratio won't hit (say) 15 times.
But that would rely heavily on the company being able to maintain its dividend yield. That's a tall order given that earnings have been on a downward trend.
If it doesn't maintain its yield, the P/E ratio must adjust lower, along with the share price.
We're seeing a similar situation in U.S. blue chip Johnson & Johnson (Exchange: New York; ticker: JNJ).
JNJ grew earnings less than 1 percent per year over the last three years, but has increased its dividends by 6.3 percent per year. Meanwhile, its P/E ratio has risen from 18.7 times to 23.4 times today.
So buying JNJ today for its dividend (which is still a respectable 2.7 percent) is exposing your capital to risk.
In short, you shouldn't buy stocks for dividends alone.
Unless you're a value investor looking for mispriced assets, growth in earnings should always be a key element in your stock investment decision making process.
Good investing,
Brian Tycangco
Editor, Stansberry Pacific Research | | | | | | | | | | | | Brian Tycangco is an investment analyst based in Manila, Philippines. He is co-editor of Strategic Wealth Confidential and editor of Extreme Growth Trader (a soon to be released trading advisory). Brian has worked in the financial field for more than two decades, and specializes is uncovering the best little-known opportunities within the Asian equities markets. He began his career as a stockbroker before joining BNP Paribas, one of Europe's largest banks, as an equities analyst. Prior to joining Stansberry Pacific Research, Brian worked for the longest running investment newsletter in Asia, and built a track record of more than a dozen double- and triple- digit gains. | | More From Asia Wealth Investment Daily | | | | | | | | | | | | | |
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