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If You Own Any of These Dividend Favorites, Your Income May be in Jeopardy
Large-cap dividend payers are usually thought of as safe stocks. These are typically companies in an industry with loyal customers, like drug companies or phone companies. But while this may have been a sound strategy for generating income in the past, some large-cap, high-yield stocks could deliver large losses to investors in the next few years.
Starting with drug stocks, the numbers show investors could be disappointed. The table below shows the yield and payout ratios of some of the largest drug companies in the world. The payout ratio is the percentage of earnings allocated to dividends. High payout ratios indicate the company dedicates most of its resources to dividends and has little money left to invest in the growth of the company.
Analysts expect these three companies to grow earnings slowly over the next few years, giving them little room for increasing dividends, since dividends are paid from earnings. When a payout ratio tops 100%, as it does for BMY, a cut is possible, although it seems unlikely that BMY will cut its dividend if it meets earnings estimates.
Telecom companies were once thought of as a safe haven for dividend investors, back when AT&T (NYSE: T) provided phones to nearly every home in America and was considered a monopoly. The telecommunications landscape has changed drastically since then. The AT&T monopoly was broken up, first by judicial decree, and then by technology. Now consumers can choose between traditional landlines from phone companies, phones that connect over the Internet, or cell phones.
Competition among phone services has helped to lower consumer prices and decrease provider profits. Yet some investors continue to think of phone companies as reliable dividend stocks. It's not hard to see why, with high dividends available from several companies. In the cell phone market, four companies control 83% of the market and three offer an above-average dividend yield.
*Trailing Dividend Yield
Now let's look at those stocks in a different way. The next table adds their share of the cell phone market, and includes Sprint (NYSE: S), which is the third-largest provider but does not pay a dividend. This chart also includes payout ratios and projected earnings growth.
This is a market where the four largest companies have little room for growth unless they win market share from their competitors. That strategy could lead to a price war, and while consumers would benefit, investors in cell phone providers could lose. Dividends exceed profits for three of these companies, so investors hoping for income could be disappointed.
All of this has been meant to illustrate the fact that investors hunting for safe income need to consider the future prospects of their investments. Because markets change, investment strategies should change as well. And one of the best strategies for income investors in the current market is selling covered calls.
Stocks with high payout ratios and low earnings growth generally have limited upside potential. They may not be able to raise their dividend because cash flow will not allow it. The stock price may not move much higher because earnings are growing slowly.
Selling a call option on a stock you own could allow you to increase your current income for the position. The income received from selling calls could also cushion the downside if prices fall. You could even create your own "dividend" by using this strategy on non-dividend-paying stocks like Sprint.
There is no need to accept slow growth and low returns when options strategies are available that can help you boost income. Review your income stocks and consider covered call strategies for those with slow growth prospects.
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