The current investment environment continues to be very challenging for investors who need income. Bond yields remain historically low, which has encouraged yield-seekers to look into alternatives, like REITS, MLPs, Utilities, lower quality bonds and stocks that pay generous dividends. The S&P 500 currently offers a dividend yield of 2%, but almost 11% of the stocks in the index offer dividend yields above 4%. Four of them offer 8% or more. In order to generate income, many investors have been purchasing higher-yielding stocks.

Unlike corporate bonds, where investors receive contractual interest payments on time or the issuer defaults and faces potential loss of control of the company, stock dividends can be reduced or eliminated with little effort by the company. There have been several high profile dividend reductions or eliminations this year, including grocer SuperValu (SVU) and electronics retailer RadioShack (RSH). In the case of SVU, where the company had already reduced the dividend previously in 2010, it suspended the dividend in July. Investors who bought the stock in June and thought it was yielding over 7% not only found out that not only is there no yield at all but also suffered a sharp price decline on the news.

In the case of RSH, which had paid a .25 dividend for several years and had boosted it to .50 in 2011, the dividend was also suspended in July. Again, shareholders who thought they were getting a 10% yield learned that they will be getting no dividend and suffered a sharp decline in the price of their investment.

While there are no assurances that a company will grow or at least maintain its dividend, there are many things an investor can do to help assess the risk of suffering a disappointing dividend disaster. Here are a few key factors to assess:

·       Balance Sheet
·       Growth
·       Payout Ratio

The balance sheet represents an assessment of a company’s assets and liabilities. In simple terms, what it owns and what it owes. Investors of high-yielding dividend stocks should be cautious when the assets are hard to convert to cash and when there is a lot of debt, especially shorter-term. There are no hard and fast rules, but the more cash and short-term assets the better, the more debt the worse. Often, when a company hits a short-term obstacle, there are covenants that protect the lender by forcing suspension of the dividend in certain scenarios. Thus, understanding the balance sheet is important, as a stronger balance sheet improves the likelihood that the dividend can be sustained.

If a company is growing its earnings, it is likely able to maintain if not even increase its dividend.  Thus, it’s important to understand what the future growth prospects might be. One can always look to history: How much have earnings grown in the recent past? What has been the history of the dividend growth? While the future, which is unknown, is more important than the past, we can gain clues from the past. For instance, as I mentioned above, SVU cut their dividend last year.

The final factor to consider is perhaps the easiest to assess: How much of the earnings are paid out in dividends? The lower the payout ratio, which divides the dividend per share by the earnings per share, the more likely a company can withstand a short-term reduction in earnings. Companies that pay out most if not all or even more than all of their earnings through dividends are at risk of having to cut the dividend.

Many investors are attracted to higher-yielding dividend stocks but don’t take the steps necessary to minimize the risk of enduring a reduced or eliminated dividend. With this in mind, I decided to screen those 54 stocks in the S&P 500 that offer rather generous yields in excess of 4% to see how many of them might stand out for potential safety. Here is what I did (using Baseline):

·       Dividend Yield > 4% (S&P 500 is 2%)
·       Payout Ratio < 50%
·       Dividend Increases in Past 5 Years:  5
·       5 Year Dividend Growth >8%
·       Projected 2013 EPS Growth > 0
·       Net Debt to Capital < 35%

Here is what we get:
 


As a reminder, remember that these are not recommendations but rather suggestions for further research. While there were 54 stocks with dividend yields in excess of twice the yield of the S&P 500, only 3 met the strict criteria of this screen.
Dividend-paying stocks can be an important part of an income-oriented investment portfolio, but it’s important to understand how secure the dividends might be. Investors in RSH and SVU, for example, lost not only their income stream but also a significant amount of their principal should they need to sell their stock. Hopefully, I have given you a few ideas about how to think about risk as well as a few candidates to consider if you are seeking higher-yielding dividend-paying stocks. Remember, screening is only a first step. Before investing, you should do your own investigation to identify risks and potential opportunities.

Regards,

Alan Brochstein
Founder, Invest By Model and AB Analytical Services
TradeKing All-Star Commentator

Disclosure:  No positions in any stock mentioned

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