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A low interest rate policy has kept returns on bank deposits near zero for the past few years, which has led investors to reach for dividend stocks to generate steady income. Dividends are easy to find: In fact, 84% of the companies in the S&P 500 currently offer a payout, with an average yield of 2%.
In the majority of cases, dividends offer investors consistency and security. With a few simple guidelines, I believe that readers can find payouts that will be rewarding and continue to grow over time.
However, I have found that investors of all shapes and sizes can be tempted by the lure of an above-average dividend yield. Investing is a total return game and readers need to remember that a higher yield carries higher inherent risks.
With that in mind, my focus for this piece and future installments will be on the viability of stocks with dividend yields north of 4%. In which cases is it worth seeking out income that is twice as much as average (or more) and in which cases is that "secure" dividend investment not as attractive as it appears?
Darden Restaurants (DRI), which closed Thursday at $51.48, is the first name that comes to my mind when I am screening for high-yielding stocks. The company is familiar to investors and consumers alike, but the stock has been dead flat over the past two years -- in what has mainly been a lucrative period for investing in U.S. stocks.
The only reason that investors have gained a fraction of a percent over the past two years in Darden (compared with nearly 30% in the S&P 500), is a function of the restaurant operator's 4.3% dividend yield.
Under its soon-to-be-departing chief executive, Clarence Otis, Jr., the company's sales had struggled for several quarters. With earnings expected to fall for a third straight year in fiscal 2015 (ending May), Darden was not in a position to raise its quarterly dividend of $0.55 a share this past June, which management had done in recent years.
In fact, with expected full-year earnings of $2.25 a share -- a 98% expected payout ratio -- it's easy to question the viability of the dividend at all. I generally look for a payout ratio of no more than 50% to 60% for a non-utility company. That figure is the average rate for the S&P 500 and allows for some leeway during a rough patch.
However, what that simple, but important, payout ratio fails to take note of in this case is a company's ability to change. In May, Darden sold its Red Lobster chain, which had been a drag on profits, for $2.1 billion. This gave management new funds to buy back stock and debt, while helping to maintain the dividend until business could improve, once a new CEO is found.
In the meantime, earlier this week, the company said that September same-store sales improved in six of seven chains, including the key Olive Garden, Longhorn Steakhouse and Capital Grille chains. Management guided November quarter earnings to the high end of previous guidance and Darden's dividend no longer appears to be on life support.
Up next is SeaWorld Entertainment (SEAS), which went public in April 2013 at $27 and expected to provide a 3% dividend yield. The stock quickly traded up toward $40 out of the gate, but recent negative press regarding animal treatment has hurt park attendance in recent quarters.
The shares have languished in 2014, falling 34%, to Thursday's closing price of $18.85. With expected full-year earnings of just $0.85, down from $1.15 in 2013, investors should be questioning the security of the company's quarterly dividend of $0.21 a share.
Management is attempting to cut costs and SeaWorld does consistently report adjusted EBITDA that is in excess of net income. That said, the company is facing increased competition in key markets, such and Southern California and Orlando. In the meantime, its net debt makes up a hefty 2.58x shareholder equity.
With limited visibility for a near-term earnings recovery, this is one rising dividend yield that I believe readers should avoid.
Finally, there's Exco Resources (XCO). The stock trades below $10 ($2.90) yet the name has a dividend yield approaching 7%. Even in a market full of declining energy small-cap stocks, the 34% loss in the shares over the past 10 trading sessions has been staggering.
Investors looking for salvation in the dividend should note that the company has only earned enough once in the past four quarter to match the quarterly payout of $0.05 a share. In addition, the current consensus analyst estimates are calling for 2014 earnings of just $0.10. In the meantime, Exco has net debt equal to 3.7X shareholder equity.
While speculative traders may choose to splash around with this natural gas name, this is one lofty dividend that does not appear sustainable.
Exco is just one of several energy stocks that have been decimated in recent weeks. Check back next week, when I will focus specifically on this industry and look at the viability of dividends, including the 10% yield from Diamond Offshore (DO).