Many people get intrigued by a stock with a high dividend yield but don't do all the work necessary to see whether the stock is a ticking time bomb. We asked our Motley Fool contributors what dividend stocks they consider dangerous enough that you should avoid.
: Medallion Financial Corp. is a specialty lender that operates primarily in the taxi industry. It lends to taxi drivers and businesses to purchase a medallion -- a legal right to operate a taxi for profit. Medallions aren't cheap; in some markets, prices even exceed $1 million.
Historically, taxi medallions have only gone up in value. In fact, Medallion Financial currently earns just 4.03% on its directly owned medallion loans -- a sign of the low risk it believes it takes when it makes loans to taxi operators.
But start-ups like Uber and Lyft are starting to change the game. In recent months, demand and prices have plummeted. In New York City, for instance, taxi medallion values dropped by 25%. In Chicago, only 11 medallions traded hands in the last six months of 2014, compared with 225 in the last six months of 2013, according to the TheNew York Times. Buyers are few and far between, worried that without regulation of car-sharing services, medallion pries will only continue to fall.
Medallion Financial's recent results also show a significant uptick in the number of delinquencies, with 2.2% of its directly owned medallion loans 31 days or more past due, up from 0.9% in the prior quarter. And although Medallion Financial reportedly lends only 50% to 75% of the medallion's purchase price, further declines in prices and a lack of interested buyers could force sellers to take big haircuts to offload the collateral.
For these reasons, the stock's 9.5% dividend yield, representing virtually all of the company's annual earnings, doesn't seem to compensate for the risk. It's a binary bet on the ability and willingness of America's municipalities to regulate car-sharing services out of existence -- an unlikely event, in my view.
: One dangerous dividend stock you should avoid is Vale .
This Brazilian resource giant has had a tough few years as the price of iron ore, its main commodity, has been crushed, with demand growth from China slowing while supply continues to expand. The price of iron ore is down over 40% in the past year, and 55% over the past five years.
The stock price has taken a beating as well, down 53% over the past year and 80% over the past five years. With the stock price down so far, even after a dividend cut the stock has an expected forward yield of 6.7%.
Vale is a cash flow-generating machine, generating nearly $13 billion in cash last year. However, Vale has multiple projects in the works that will eat up that cash flow. To provide cash, the company has been taking on debt and is planning on holding an initial public offering for its copper, nickel, and other base-metals business.
Dividend investors should be wary. For iron ore prices to pick up, demand would have to grow more quickly or supply would have to contract. Neither seems likely. As the largest iron ore producer in the world, the supply is one factor that the company has a lot of say in. However, both Vale and the third largest iron ore producer, BHP Billiton, have essentially stood by their plans to significantly expand their iron ore operations. This should further weigh on iron ore prices for quite some time and raises the possibility of a dividend cut when Vale needs the cash flow for its projects.
Todd Campbell: PDL Biopharma's 8.7% forward dividend yield becomes far less enticing when we recognize that the revenue stream allowing for that dividend payout faces a major risk.
The company's fat dividend is fueled by royalty revenue stemming from a monoclonal antibody patent portfolio that covers some of the globe's top-selling cancer drugs, including Roche Holdings'Avastin and Herceptin.
Those patents have paid off handsomely over the past decade, but with patents and royalty agreements expiring, PDL Biopharma is about to have a lot less revenue on its hands to dole out.
In an attempt to blunt some of the expected drop-off, PDL has invested $780 million in non-dilutive capital deals and financing agreements with clinical-stage biotech companies. However, it's unclear to me just how much revenue risk these investments can offset. As a result, while PDL's dividend yield is one of the best in healthcare, the risk of a dividend cut and a falling share price makes this one that dividend investors ought to avoid.
Dan Caplinger: Many dividend investors have gravitated to high-yielding utility stocks, with companies like Duke Energy offering above-market dividend yields in the 4% to 5% range. Yet what many utility investors don't understand is that stocks like Duke Energy tend to be highly correlated to interest rates, and when rates go up -- as many believe is imminent in the near future -- their share prices go down.
It's true that the interest rate risk that utility stocks bear is different from the risk of falling quarterly payouts that most people focus on with dividend stocks, as Duke isn't in any immediate danger of having to cut its dividend. Based on current earnings projections for this year and next, Duke could pay dividends of up to 6% without fully tapping its net income, making its current 4.2% yield look conservative by comparison. Yet even if it keeps its dividend stable, rising rates will make Duke's debt more costly to maintain, potentially eating into earnings growth and pressure the company's stock price. That could send utility stocks down enough to outweigh the dividend income they produce. Utilities make good picks later in the interest rate cycle when their yields are even higher and their share prices are likely to jump as rates fall. For now, though, there are better dividend stocks you should target for your portfolio.
The article 4 Dangerous Dividend Stocks You Should Avoid originally appeared on Fool.com.
Dan Caplinger has no position in any stocks mentioned. Dan Dzombak has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. Todd Campbell has no position in any stocks mentioned. The Motley Fool owns shares of Companhia Vale Ads. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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