AMLP - What I Wish I Knew Before Becoming A Dividend Investor

2023-04-19 11:21:48 ET

Summary

• Dividend stocks can be extremely rewarding investments, with a proven track record of outperforming the broader stock market.
• That said, there are plenty of pitfalls to dividend investing.
• I review three of the most important lessons that I wish I had learned before investing in dividend stocks.

Dividend stocks can be extremely rewarding investments, with a proven track record of outperforming the S&P 500 ( SPY )( VOO ) over the long-term. As the chart below illustrates, dividend paying stocks crushed an equal-weighted S&P 500 index over a ~45 year period:

Moreover, in the years since that study was completed, dividend stocks as represented by the popular fund called Schwab US Dividend Equity ETF ( SCHD ) have continued to (slightly) outperform SPY:

While the outperformance was narrow, it is actually particularly impressive given that this period saw very strong performance for high growth tech stocks, which make up a large portion of SPY. For example, over this period the big tech giants of today that dominate SPY's top holdings such as Amazon ( AMZN ), Apple ( AAPL ), Alphabet ( GOOG )( GOOGL ), Microsoft ( MSFT ), Tesla ( TSLA ), and NVIDIA ( NVDA ) (none of whom are in SCHD's holdings ) put up huge numbers:

This shows that across multiple economic cycles, across massive technological disruption, through terrorist attacks, wars, raging high inflation, rising interest rates, COVID-19 lockdowns, geopolitical turmoil, etc. dividend stocks have consistently generated attractive returns that have ultimately beaten the market.

For prudent active investors who run more concentrated portfolios than the 100+ stocks that SCHD holds in its portfolio and have successfully avoided many of the big losers in the dividend space, the total returns have been even more impressive.

While I am far from perfect and have had my fair share of big losers (such as Hanesbrands ( HBI )), by actively managing my high yield dividend stock portfolio I have been able to significantly outperform SPY as well as every other dividend ETF in the market, including the Global X Super Dividend U.S. ETF ( DIV ) since launching the High Yield Investor Core Portfolio in December 2020:

That said, as my failures have illustrated, there are plenty of pitfalls to dividend investing that can be very difficult to avoid if you do not know what to look for. In this article, I review three of the most important lessons that I wish I had learned before investing in dividend stocks.

#1. Balance Sheet Strength Is Critically Important To Dividend Stock Investing

My biggest and most common investing mistake in the past has been not putting enough emphasis on balance sheet strength when selecting dividend stocks.

It can be very easy to make this mistake for two big reasons:

• Sometimes certain balance sheet strength metrics can be misleading about a company's true financial health.

For example, a common leverage ratio used in many industries is Net Debt to EBITDA. While this does offer a pretty good overview of how well a company can service its debt, the EBITDA figure can often vary widely from one year to the next. If a company with a high amount of operating leverage is coming off of a boom period for its business, its leverage ratio may very likely be quite low and an investor who casually glances at that metric may quickly assume that the balance sheet is in great shape and move on to analyzing other parts of the business.

However, when the macroeconomic situation shifts and the company's revenues decline, its high operating leverage kicks in and EBITDA suddenly plummets. This may result in the leverage ratio soaring to levels that at a minimum may prompt management to stop growing the dividend in order to prioritize deleveraging, but in many cases actually prompt them to slash or even eliminate the dividend entirely. When this happens, the stock price typically plummets as well. While this is a risk with any company with substantial operating leverage, if it is in a cyclical industry (such as automotive firms like General Motors ( GM ) and Ford ( F ) or my earlier example of an apparel firm like HBI of V.F. Corporation ( VFC )), this is even more the case.

• Interest rates can rise rapidly.

If the past year has taught us anything, it is that interest rates can rise very rapidly:

What this means for business balance sheets is that if it has a significant amount of floating interest rate debt on its balance sheet and/or substantial debt maturities coming due in the near term that it will need to refinance, it is as considerable interest rate risk. It could have a strong investment grade credit rating, low leverage metrics, and a strong business model, but if it has substantial exposure to rising interest rates, its balance sheet could be at risk.

This happened with Algonquin Power & Utilities ( AQN ) recently. Despite possessing a BBB credit rating, having a stellar dividend growth track record, and an impressive portfolio of high-quality, defensive assets, it had substantial exposure to rising interest rates. As a result, its interest expense soared, prompting management to roll back its growth plans and to slash its dividend quite aggressively. Shareholders paid a steep price as well:

#2. Dividend Stocks Are Rarely As Cheap As They Seem

While juicy dividend yields and stock charts that show a company is trading at well below its 52-week highs often jump off the page at dividend investors as compelling buys, the investment proposition is seldom as appetizing as it first appears.

We - like the legendary Warren Buffett of Berkshire Hathaway ( BRK.A )( BRK.B ) - do not subscribe to the efficient market hypothesis:

Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards. ~ Warren Buffett

However, we also believe that the market is seldom stupid. If a stock is trading at a steep discount to its recent highs and offers a sky-high dividend yield, there is virtually always a good reason for it. As a result, while deeply undervalued opportunities do get our attention, we typically cast a very skeptical eye towards them.

At a bare minimum, virtually any stock that is trading at a very high dividend yield relative to its normal range probably belongs in the high risk category of investments. Many of these do turn out to be highly profitable investments, but a large number also turn out to be big losers, some of which actually go all the way to zero (just ask some of the mall REITs that were reportedly extremely cheap and offered sky-high dividend yields before going bankrupt).

A classic recent example of this was Lumen Technologies ( LUMN ), a business that boasted a sky-high dividend yield that was covered very well by free cash flow. Moreover, management was speaking excitedly nearly every chance they got about the exciting growth potential for the business. Meanwhile, the stock traded at a deep discount relative to the estimated private market value of its assets on an EV/EBITDA basis. With a sure winner like this, what could go wrong? Well, it turns out that its assets were in fact not anywhere near growth and the growth businesses it did have required significant CapEx. As a result, the relentless declines in its revenues and EBITDA along with the growing CapEx demands were greatly straining its balance sheet. As a result, it eliminated its dividend and the stock price completely cratered:

A cheap stock is almost always cheap for a reason and has a very good chance of getting even cheaper. When Mr. Market waves a yellow or red flag, it is almost always for good reason. Buyer beware.

We have generally found that a better risk-adjusted way to invest in dividend stocks is to buy companies that:

• still have very healthy fundamentals
• while still clearly undervalued, are not necessarily deeply undervalued.

These are often cases where the company is simply misunderstood by Mr. Market:

• It could be fairly new to the public markets (for example, Blue Owl Capital ( OWL )) and not be fully understood/trusted yet.
• It could have a quirky business model with very light analyst coverage.
• It could suffer from negative headlines and political pressures that do not actually impact its business fundamentals.

Meanwhile, these businesses continue to pay out attractive dividends and grow their intrinsic value year after year, so buying them at a discount is a phenomenal opportunity.

#3. Assessing Dividend Safety Involves Far More Than Looking At The Payout Ratio

Similar to lesson number one about balance sheet strength being about far more than the leverage ratio, assessing the safety of a dividend involves far more than merely seeing how low the payout ratio is. This is because:

1. A safe payout ratio depends greatly on which industry you are looking at. A conservatively run REIT ( VNQ ) like Realty Income ( O ) or a conservatively run MLP ( AMLP ) like Enterprise Products Partners ( EPD ) can generally handle a much higher payout ratio than a highly leveraged cyclical apparel company.
2. The strength of the balance sheet matters as much - if not more - to the safety of the dividend than the level of the payout ratio.
3. The CapEx demands for the business play a huge role in determining the safety of the dividend. Many times the payout ratio does not take this properly into account.

A classic example of this is AT&T ( T ). The company had a very impressive multi-decade dividend growth track record, an investment grade balance sheet, a relatively low payout ratio, and had been a fixture in the American economy for decades and decades. The stock paid out a very high yield and was very popular with income investors, particularly retirees who viewed it as a higher yielding bond substitute that also generated a little bit of growth.

Unfortunately, management had destroyed tens of billions of dollars in shareholder value in recent years through some ill-fated acquisitions and piled up an immense debt burden.

Moreover, T had a huge CapEx burden ahead of it as the company was needing to invest aggressively in its growth streaming media business as well as in upgrading its telecom infrastructure to fiber and 5G. With interest rates and inflation rising rapidly, both its capital expenditure burden and debt burden got heavier. As a result, despite having strong free cash flow coverage of its dividend and a long track record of growing its dividend, management felt compelled to slash the dividend in order to prioritize preserving its investment grade balance sheet and fund its CapEx requirements.

Investor Takeaway

Dividend investing is a proven way to compound wealth at high rates of return over the long-term. It has served me very well and I encourage you to give it a try too if you haven't already.

That said, it is not an easy path either, especially if you want to pick your own stocks in an effort to maximize the income and return potential that dividend investing can generate.

However, if you can keep the three key lessons discussed in this article in mind, and apply them appropriately, you will avoid a lot of stress and financial losses without having to learn the hard way.

Let me know below: what is an important lesson that you have learned about dividend investing?

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