When Dividend Stocks Appear Too Good to Be True

NEW YORK (TheStreet) -- Given low interest rates -- the 10-year Treasury is yielding only 1.6% -- it is remarkable that there are nearly 500 companies with markets values over $500 million that yield more than 3.2%.

It is a foregone conclusion, in my view, that rates will rise substantially in the coming years. It's just a matter of when. When that happens, bond owners will see the value of their holdings drop; the longer the term, and lower the coupon, the greater the damage. That is simple bond math, and it is the reason many pundits are advising that the duration of bond portfolios be shortened.

But owners of dividend-paying stocks face their own share of risks. There's always market risk; stock prices can fluctuate wildly. There's plenty of evidence to suggest that high-quality dividend-paying stocks face a lower level of price volatility, and that the dividend may help put a price floor in place. It is unlikely that a high-quality name yielding 4% will see its price cut in half, at least for very long, assuming the fundamentals are intact, and that there's not trouble brewing specific to that company or industry. If the story is intact, theoretically, new buyers will emerge, taking advantage of the now 8% yield, pushing the price higher and the yield lower.

One of the greatest risks to those seeking yield through dividend-paying stocks is the possibility that the dividend is either reduced or eliminated. That is typically a signal that all is not well with the company, but there are often warning signs that investors should be aware of. Ultimately, dividend cuts or eliminations are rarely a surprise when announced.

Declining earnings and rising dividend payout ratios can indicate that a cut may be coming. A disappointing quarter or two, where the overall story and fundamentals remain intact is typically not cause for panic. But a sustained rise in payout ratio, declining earnings, rising debt level, and decreasing liquidity should not be ignored; especially if the company is in an industry that is struggling or in decline.

Yields that appear too good to be true are another potential red flag. That signals that the market is expecting a dividend cut, and pricing in that reduction. The market is not always right, but in my experience, if the dividend appears too good to be true, and that's the only reason you are buying a particular name, it's time to take a step back and review the situation.

That's what the market is saying about retailer Radio Shack ( RSH), which is currently paying a $0.125 quarterly dividend that equates to an 11.5% yield, well above its seven-year average (1.7%). Revenue has been stagnant and earnings have declined for several years, and this is not just an issue for Radio Shack. Electronic retailers in general have suffered with the greater competition that has emerged from online retailers. Best Buy ( BBY) has also been hurt. Radio Shack management recently said it intends to keep the dividend intact, but the market isn't buying it. Radio Shack still has plenty of cash, and from a balance sheet perspective, the company is interesting, but I would not buy it just for the yield.

Gannett ( GCI), parent of USA Today, is also an interesting story, but more from the perspective of how these stories can play out. When the market imploded in late 2008/early 2009, Gannett shares, which traded for more than $90 in 2004, fell below $2. Late in 2008, before a 90% dividend cut, shares were "yielding" more than 20%, a great indicator that a cut was coming. The stock price continued to fall. When the dividend was cut from $0.40/quarter to $0.04, the yield "fell" to the 7% range. Frankly, I believe that the market was surprised that Gannett did not eliminate the dividend altogether. From there, the stock began to rise, via the combination of the overall markets recovering and the realization that conditions were not as bad for Gannett as the market believed.

There's a postscript to this story, one that is fairly uncommon. As the company began reporting quarterly numbers that were typically ahead of expectations, calls for the company's untimely death became fewer. The stock is still unloved, primarily due to the fact that it is perceived as a newspaper company, a dinosaur. But last September, the company doubled the dividend. Then in early 2012, Gannett raised it again to $0.20, a 250% increase. The current dividend at $0.20 is half what it was back in the company's heyday, but given the amount of free cash flow the company is generating, and the low 22% payout ratio, further increases may be in store.

Mr. Market, however, in his ultimate wisdom, isn't buying this story, a point demonstrated by Gannet's indicated yield of 6.35%. Stay tuned.

The writer owns a position in Gannett.

Jonathan Heller, CFA, is president of KEJ Financial Advisors, his fee-only financial planning company. Jon spent 17 years at Bloomberg Financial Markets in various roles, from 1989 until 2005. He ran Bloomberg's Equity Fundamental Research Department from 1994 until 1998, when he assumed responsibility for Bloomberg's Equity Data Research Department. In 2001, he joined Bloomberg's Publishing group as senior markets editor and writer for Bloomberg Personal Finance Magazine, and an associate editor and contributor for Bloomberg Markets Magazine. In 2005, he joined SEI Investments as director of investment communications within SEI's Investment Management Unit.

Jon is also the founder of the Cheap Stocks Web site, a site dedicated to deep-value investing. He has an undergraduate degree from Grove City College and an MBA from Rider University, where he has also served on the adjunct faculty; he is also a CFA charter holder.

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