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Yields That are Too Good to be True
Despite a share price that had been falling since mid-2007, some investors had been discussing the purchase of shares of grocery-company SUPERVALU (SVU) based on its relatively high dividend yield. Few were deluding themselves into thinking that the company was a rock solid competitor with huge growth potential because it was obviously dealing with a very challenging business environment. However, the yield was reaching the point where dividend focused investors were starting to salivate, and those who stepped in to buy surely convinced themselves that a turnaround was in the cards. Indeed, if management was successful at turning the business around, and the dividend was maintained, SUPERVALU would have turned out to be a great investment.
On July 12th, however, SUPERVALU shares plummeted after the company indicated that its ongoing turnaround efforts had faltered. Earnings for the first quarter of fiscal 2012 (year ends February 23, 2013) fell 46% from the year-earlier period, comparable store sales were down about 3.5%, and so-called “shrink” (theft) and marketing costs remained elevated. Worse, for a dividend investor, the company suspended its payout.
SUPERVALU turned out to be a dividend trap; the story was simply too good to be true. That isn’t to suggest that every high-yielding company is just like SUPERVALU, which is clearly not true. However, it is important to take a critical look at what is going on and to consider all of the potential outcomes—not just the best case scenario. Indeed, buying SUPERVALUE at a yield around 6% is simply not the same thing as buying Dow-30 component Johnson & Johnson (JNJ – Free Johnson & Johnson Stock Report) yielding around 4%. The latter company’s business is still fundamentally strong, while the former’s was (and still is) inherently weak.
Very few companies grow in perpetuity. There are almost always bumps along the way. These bumps vary in size and can often lead to great bargains for patient investors. This is particularly true for investors focused on dividends, since dividend yield can be used as a valuation tool and a source of return. That said, there are some signs to watch for when looking at a company that may suggest things are not going in the right direction.
First and foremost would be the dividend trend. An investor should be concerned if a long time dividend increaser suddenly stops increasing its dividend disbursement. Worse would be a dividend cut, as more cuts, or even cessation, could follow. These are very visible and easily spotted trends that should be on the minds of dividend investors. These trends can be seen over time in the historical portion of the Statistical Array Value Line provides for each of the 1,700 companies it covers. All three are often associated with a steep stock price decline—dividend cessation usually resulting in the steepest drop. If the trends on the dividend front are questionable, it is important to either find out why or simply to move on to another opportunity.
Harder to quantify is when dividend growth rates slow, though this should be examined, as well. The Annual rates data on each Value Line report provides historical annualized growth rates for the past five and 10 years. It also includes the projected annualized growth rate over the next three to five years based on our analyst’s opinion of the company’s long-term prospects. A slowing trend is not ideal, but there are reasons why it might be acceptable, such as a maturing business. Still, it is important to note the dividend growth trend, even if it turns out to be a non-issue.
Some companies, however, continue to increase their dividend payments despite suffering through hard times. This can result in a buying opportunity, or not. A good example of this would be Pitney Bowes (PBI), which currently sports a 10%-plus dividend yield. The company makes postage meters, a troubled business at best since e-mail is increasingly replacing paper mail delivery. However Pitney Bowes is still very profitable and is making changes to its business model to adjust to the digital world. It has also continued its impressive streak of annual dividend increases. That’s great, but its business model is a major concern and has led investors to dump the shares. Thus, investors considering an investment in Pitney Bowes based on its impressive yield need to take a critical look at its business. Having done this at SUPERVALU might have led investors to look for other options. Will Pitney Bowes turn itself around? That’s hard to tell, but it is one of the most important questions to decide before investing. Value Line’s analyst opinion on the matter can be found in the Analyst Commentary section of each company report.
Turning a business around requires financial flexibility. That can come in the form of cash in the bank, room on the balance sheet for more debt, or a solid stream of earnings, but no turnaround effort goes perfectly and a lack of flexibility isn’t a promising attribute. A look at debt levels, cash on hand, and Value Line’s proprietary Financial Strength rating are all important. So, too, are the trends—looking at the long-term debt line of the Statistical Array on a Value Line report can give an idea of not just how much debt a company has, but how that level has changed over time. A rapidly increasing figure is typically a bad sign. With regard to cash, the Current Position box on a Value Line report shows the cash balance at the end of the last two fiscal years and the level at the end of the most recent quarter. Clearly, more cash is better. While looking at that section of the report, divide Current Assets by Current Liabilities to derive the company’s current ratio—a measure of its ability to pay its short-term obligations.
These are a few examples of what an investor might watch for when considering a company with a materially above market dividend yield. There are bargains to be had in this space, but there are also companies faltering for good reason. It is important to take a hard look at a company before jumping at a high yielder.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.