High Dividend Stocks: Reaching for Yield May Be Risky

The global bond market is in uncharted territory as a consequence of extraordinary monetary policies adopted by central banks. Savers are faced with paltry yields available from bonds, with 36 percent of government bonds trading at negative yields and 74 percent with yields less than 1 percent. U.S. Treasurys are a higher yielding alternative, but with the 10-year offering a yield of about 1.5 percent, many investors seek higher yields than are available in the global bond market.

High dividend stocks have been big winners this year, benefiting from interest from investors fleeing anemic bond yields. The reach for yield may be risky for complacent investors who ignore the elevated valuations and uncertain prospects for some of the most popular dividend plays. Investors seeking yield should understand the risks, and consider factors beyond dividend yield when evaluating dividend-oriented investments.

Utilities and telecommunications stocks: 2016 performance leaders may face headwinds. Utilities and telecommunications were the best performing sectors in the Standard & Poor's 500 index during the first half of 2016, and despite weak performance in recent weeks still are among the best year-to-date performers.

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Many investors have crowded into utilities stocks, attracted by high yields and the sector's history of low volatility in comparison with the broader stock market. Many investors of exchange-traded funds have substantial indirect investment in utilities, as some popular dividend ETFs have also crowded into utilities stocks. As of June 30, the iShares Select Dividend ETF (ticker: DVY) invested about 33 percent of its assets in utilities, and the SPDR S&P Dividend ETF ( SDY) invested about 15 percent of its assets in utilities.

The utilities sector offers approximately a 3.6 percent dividend yield, an undeniably compelling yield given today's low interest rates. Unfortunately, the dividend yield offered by utilities comes at a steep price. Utilities trade at an eyebrow-raising 17x next year's earnings -- a high price-earnings ratio relative to the market and to the sector historically . Utilities companies face numerous challenges, given slow earnings growth, an uncertain regulatory environment and external threats caused by increased energy conservation and the growth of renewable energy sources.

In addition to the challenging environment for the utilities sector as a whole, many utilities face company-specific challenges. Notably for many utilities, the dividend payouts coveted by investors are not covered by current earnings or cash flows, creating a low "margin of safety" covering dividend payments. High valuation and low margin of safety may be warning signs clouding the outlook for utilities stocks.

Telecommunications stocks trade at less lofty valuations, but also face growth challenges, high debt burdens, and significant capital expenditure commitments. AT&T ( T) is struggling with tepid earnings growth, pricing pressures and considerable debt taken on as a result of the acquisition of DirecTV, expansion into Mexico and capital expenditures to improve its network coverage. Verizon Communications ( VZ) may have some growth and network advantages relative to AT&T, but also has a heavy debt load, in part because of the 2014 buyout of Vodafone's stake in Verizon Wireless.

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Consumer staples and energy stocks may also face challenges. Consumer staples stocks may also be vulnerable, trading at more than 20x next year's earnings. Companies such as Procter & Gamble Co. ( PG), General Mills ( GIS) and Kellogg Co. ( K) boast attractive yields and robust cash flows, but may not deliver the growth necessary to support elevated earnings multiples.

Energy companies are struggling to generate the cash flow necessary to maintain attractive dividend yields, pressured by low energy prices and substantial capital expenditure needs. Chevron Corp. ( CVX) is one high-profile company that may be straining resources in efforts to sustain a high dividend payout. Chevron management has been vocal about the importance of maintaining the dividend, with their CFO calling it the company's No. 1 priority. Chevron generated about $19 billion in operating cash flow in 2015, which would be a staggering level of cash flow for most companies. However, Chevron had $29 billion in capital expenditures in 2015 while paying out nearly $8 billion in dividends. Chevron is working to reverse its negative cash flow by selling assets and cutting capital expenditures, but the process of improving the company's cash flow is likely to take considerable time and will leave the company vulnerable to economic shocks.

There are several factors to consider in selecting high-dividend investments:

1. Valuations: Dividend-paying stocks are among the more expensive parts of the market today. Eventually the "crowded" trade among dividend stocks may be become less crowded, and the market will transition from a "dividend yield at any price" environment to a more discriminating environment in which valuations relative to growth prospects will become more important.

2. Margin of safety: Some dividend yields are "safer" than others. Dividend payments aren't guaranteed and can be suspended by the company. The capacity to maintain the dividend is an important criteria to consider, and can be measured by evaluating the percent of earnings paid out as dividends as well as the percent of cash flow paid in dividends. Cash flow is harder to manipulate and often less variable than earnings, so many investors look at cash flow metrics as the more important measure. The lower the ratio, the higher the margin of safety associated with the dividend.

3. Growth of cash flow and earnings: Companies with faster growth justify a higher earnings multiple and may have a greater capacity to grow dividend payouts.

4. Sector and industry diversification: Although sectors such as utilities and telecommunications tend to have high dividend yields, a portfolio concentrated in a limited number of sectors can make for a more turbulent ride. Identifying dividend-paying opportunities outside the highest yielding sectors may be a prudent diversification strategy to smooth the ride in volatile markets. Technology is an increasingly popular sector for dividend-paying stocks, as mature technology companies such as Apple (AAPL), Cisco Systems (CSCO), and Microsoft Corp. (MSFT) are distributing more of their substantial cash flow to investors in the form of dividends. Many dividend-oriented investors seek dividend-yield throughout all sectors, finding the "best" payers in each sector while paying attention to valuations, margin of safety and growth in cash flows and earnings.

Dividend stocks are an important component of an income-seeking portfolio, but may offer traps for the unaware. Investors who consider factors beyond yield are more likely to achieve their desired results.

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Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements and nothing in this communication is intended to be or should be construed as individualized investment advice. All statements other than statements of historical fact are opinions and/or forward-looking statements (including words such as believe, estimate, anticipate, may, will, should, and expect). Although TFC Financial Management believes that the beliefs and expectations reflected in such forward-looking statements are reasonable, it gives no assurance that such beliefs and expectations will prove to be correct. All content is of a general nature and solely for educational, informational and illustrative purposes.

Dan Kern is chief investment strategist for TFC Financial Management, a wholly independent, fee-only, financial advisory firm based in Boston. TFC's revenues are derived solely from the fees it charges for the services it provides. Prior to joining TFC Financial Management, Dan was president and CIO of Advisor Partners. He is also a former managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds, and was managing director and principal for Montgomery Asset Management. Dan graduated from Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco, and sits on the board of trustees for the Green Century Funds.