Investing to maximize dividend income is a great strategy for beginner investors. Who doesn’t want a portfolio that earns a regular stream of cash payments?
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High-yielding investing is a major pitfall for new dividend investors
However, new investors need to be aware of one major pitfall: buying the highest-yielding stocks you can find. Stocks with high dividend yields can be very tempting for their immediate, outsized cash returns. However, these income stocks can be very deceiving.
Stocks with elevated dividend yields (those with a dividend yield over 7%) often face serious issues, including competition risk, declining sales, bloated balance sheets, poor management decisions, and/or an unsustainable dividend payout. The market often drops the stock price to increase the risk premium on the yield.
The stock market is generally very efficient at sniffing out whether a business has an unsustainable dividend. An outsized dividend yield is often the first sign that something is not okay with the business. Unless you have a special scoop as to why that is not the case (and the market is wrong), stocks with elevated dividend yields are best avoided.
What is the point of collecting an 8% yield if your stock value declines by -20% to -50%? What is the point of buying a stock with a high yield if that dividend ultimately gets cut or removed completely?
TELUS: A perfect case study
TELUS Corp. (TSX: T) is a perfect example of a dividend trap. The company pursued an aggressive infrastructure build-out over the past five years. It kept increasing its dividend to keep up with a long-term dividend growth track record. For several years, it promised shareholders that it was going to see a wave of cash as its heavy capital plan was completed.
However, rising cellular competition in Western Canada meant that it could no longer earn the anticipated returns it had hoped for. As a result, it was left with a massive pool of debt and the wave of cash flow never showed up.
Telus’ dividend was no longer sustained by earnings or cash flows. Its dividend yield rose as high as 11.7% before it was cut. Its payout ratio was as high as 165%, which shows you how unsustainable the dividend had become.
Even since the dividend cut, TELUS’ stock price has continued to decline. It has fallen approximately 13% since the dividend cut, 42% in the past year, and 45% in the past three years. Even with the dividends earned, shareholders have earned a negative-34% total return. This is exactly the outcome you want to avoid as a dividend investor.
Choose dividend growth over dividend yield
Investors are smart to take a haircut on dividend yield but make up for it with dividend growth. The best income stocks are those that can sustainably increase their dividends per share as their earnings and cash flows per share increase.
The best part is that as those earnings grow, so too will the stock. You get to compound your stock value and your income value with time. If I were looking for some stocks with these characteristics, I would look at Canadian Natural Resources, Royal Bank of Canada, Fortis, and AltaGas.
