As Dividends Get Slashed, Investors Must Be Careful
Dividend-paying stocks, seen as a safer bet as the broader market deteriorates, have become a trickier play as some companies cut or eliminate dividends to shore up balance sheets.
At least 10 major companies have taken actions against their dividends this quarter as the crumbling economy puts pressure on earnings.
Among them, Bank of America (NYSE: BAC) reduced its usually reliable dividend to a penny, and Motorola (NYSE: MOT) on Tuesday said it would suspend its five-cent per share dividend. Department store chain Macy's (NYSE: M) slashed its dividend to five cents from 13.25 cents as the company announced 7,000 layoffs and warned of a rough economic road ahead.
U.S. & World
The day's top national and international news.
The changes make for an even more challenging investing environment.
"You just don't know who the next company's going to be to take a look at this thing—and their earnings are bad so they cut their dividend," says Nadav Baum, managing director of investments for BPU Investment Management in Pittsburgh and a proponent of dividend-paying stocks even in the weakened financial sector. "That's a tough scenario for investors."
To navigate the minefield, market pros are taking various strategies—paramount among them looking for plays that take advantage of high dividends but minimize risk.
"We're very cognizant of which dividends are sustainable," says Emily Sanders, CEO of Sanders Financial Management in Atlanta. "While all CEOs will protest loudly that dividends are secure, there are chinks in the armor now because some are having to cut dividends to raise capital or preserve cash, or companies that are recipients of the TARP (government rescue funds) have uncertainty."
Companies on shaky ground have been paying large, sometimes-double digit dividends, but Sanders calls them "accidental high-yielders" that are using high dividends to compensate for low stock prices. She's avoiding them mostly, though some of the companies, such as Dow Chemical (NYSE: DOW), could be good investments should the dividends hold up.
But there have been indications recently that Dow's board could cut its astronomical 14.5 percent dividend, underscoring the difficult choices investors face.
"If you see dividends getting into double digits of common stocks that's usually a sign that something's got to give," Sanders says.
ETFs, Selected Other Plays
Yet Baum remains an advocate for dividend payers. Solid companies with good balance sheets, though increasingly difficult to find, will still pay solid dividends ahead even if their share prices take their lumps as Wall Street continues to try to regain its footing, he says.
So he's employing a strategy that's becoming more popular among those who still believe in equities yet want protection from downturns: Buying exchange-traded funds of dividend-paying stocks that contain a basket of companies, so that if a few do cut dividends the larger fund will still deliver a return.
"I'm still a big dividend buyer, but now as opposed to looking at individual equities...I think you spread out the risk and go to the ETF models," Baum says. "When you take a look at the history of the markets, dividends are a big piece of the puzzle."
One of the most direct vehicles to get financial sector dividends from an ETF is the Financial Select Sector SPDR (NASDAQ: XLF), which holds BofA but also contains a slew of other performers that is allowing the fund to pay a 6.16 percent dividend.
With the demand for the financial sector to play a leadership role when the stock market recovers, investors would be wise to find a safe way to participate.
Video: Squeeze Bondholders to Save Banks?
"Markets always hit bottoms when it's the worst doom and gloom, and it's doom and gloom for the market now," Baum says. "For the market to truly rebound, for it to have a sustainable rebound, the financials have to be a part of it."
Outside the financials, some analysts have utilities, health care and some insurance companies poised to hold dividends.
The key, they say, is to stay away from companies that are paying exorbitant yields but have shaky financial pictures. Troubled companies need to pay high rates to compensate for the risk involved.
- Stock Picks: Two Financials With a Future
- Charts: S&P May Rally Short-Term
- Slideshow: Are My Mutual Funds Safe?
"Dividend stocks have always been a segment of the asset class that offers downside protection. The real risk is, will they continue to pay," says Tom Busby, of the Diversified Trading Institute. "Try to think of the basic needs of people and go from there as your general premise."
Busby recommends MetLife (NYSE: MET) as a company paying a modest 2.6 percent dividend but offering safety and stability going forward.
Elsewhere, Baum also is taking the dividend play to fixed-income ETFs that may even offer stronger stability and more reliable yields than equities.
Among those he uses are the iShares iBoxx Investment Grade Corporate Bond (NASDAQ: LQD) fund and its 5.55 percent dividend, as well as its iBoxx High Yield Corporate Bond (NASDAQ: HYG) fund with an 11.1 percent yield.
"There's a lot in the ETFs and the fixed-income areas where you can get some good yield right now and get some growth on it as well as this credit crisis continues to thaw out," Baum says. "All this stuff with the stimulus the government is doing at some point is going to kick in."For more stories from CNBC, go to cnbc.com.