The ongoing rise in bond yields is sparking fresh concerns about the outlook for dividend stocks, since income-oriented investors will often buy safer U.S. Treasury bonds instead if they offer similar yields. Therefore, investors should be more selective about the dividend stocks they buy this year.
I generally follow three rules for picking dividend stocks — or, from another perspective, three rules for picking which dividend stocks I should avoid.
First, I check the company’s cash dividend payout ratio — the percentage of its free cash flow (FCF) paid out as dividends. If it’s over 100%, then its dividend could be unsustainable. Second, I check if its yield is higher than the 10-year Treasury’s yield, which is currently 1.6%. If it pays a lower yield, the stock’s value is more exposed to rising bond yields.
Last but not least, I consider the long-term performance of the company’s stock, specifically looking to answer one question: Have declines in share price more than offset any dividend gains? If that has been the pattern, the stock is liable to be a poor income investment.
At first glance, IBM appears to be a great dividend stock. The tech giant became a Dividend Aristocrat last April when it raised its payout for the 25th straight year. At current share prices, its dividend has a forward yield of 5%, and the company spent just 39% of its free cash flow on the payout over the past 12 months. The stock also looks cheap at 11 times forward earnings.
I recommended IBM last August as a dividend stock because its low valuation and high yield seemed to limit its downside potential. However, I can’t reiterate that recommendation today for two simple reasons.
First, IBM plans to split into two companies by spinning off its slower-growth managed infrastructure services business later this year. Shareholders will receive stock in both companies when the split occurs.
Management says the two companies will initially “pay a combined quarterly dividend that is no less than IBM’s pre-spin dividend per share” — but that each company will subsequently dictate its own dividend policy. Therefore, the “new” IBM, which plans to expand its hybrid cloud and artificial-intelligence businesses, could reduce its dividend to redirect more cash toward investing in growth. Meanwhile, the new spinoff housing its slower-growth IT services could maintain its dividend payout or even keep raising it, but its share price could also continue to lag the market.
Second, IBM’s stock price declines have consistently wiped out the value of its dividend hikes. Shares are down 10% over the past five years. Even after factoring in the impact of reinvested dividends, the stock generated a total return of just 12% during a period when the S&P 500 nearly doubled.
Investors shouldn’t judge a stock based on its past performance alone, but IBM’s pain probably won’t end after it splits. In short, this company could lose its Dividend Aristocrat title soon, and both of the two new companies it is becoming could keep underperforming the broader market.
Altria, the largest tobacco company in America, also would seem at first glance to be a solid dividend stock. It has raised its dividend every year since it spun off its international business as Philip Morris International (NYSE:PM) in 2008, it pays a forward yield of 6.9%, and it spent 77% of its free cash flow on those payments over the past 12 months.
The stock also looks dirt cheap at 10 times forward earnings. But like IBM, Altria is cheap for obvious reasons.
The company still generates most of its revenue from selling cigarettes in the domestic market, including its flagship Marlboro brand. However, smoking rates in the U.S. have consistently fallen over the past five decades, and Altria has repeatedly raised prices, cut costs, and repurchased its own shares to offset that secular decline.
Those moves have enabled Altria to grow its earnings per share even as its revenue growth stalled out, but it’s an unsustainable strategy that is generating diminishing returns.
The imminent end of this cycle is causing Altria to make desperate investments, including purchasing big stakes in the e-cigarette brand Juul and the cannabis company Cronos Group in an effort to diversify its business.
It’s also selling Philip Morris’ IQOS heated tobacco devices in the U.S., and launching new products like nicotine pouches to expand its portfolio of smokeless products. Yet many of these efforts still face intense scrutiny from government regulators. And already, it has recognized that it severely overpaid for its 35% stake in Juul: In two separate writedowns last year, it devalued that $12.8 billion investment by a total of $8.6 billion. Its other big investments could fizzle out as well.
All of this helps explain why Altria’s stock is down 18% over the past five years. Its total return of 10% is even lower than IBM’s, and it will likely continue to underperform the S&P 500 as its core business withers and it runs out of room to raise prices and cut costs.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.