Do You Recognize This Rookie Dividend Investing Mistake?
The No. 1 Dividend Investing Mistake
Today’s chart highlights the biggest blunder you can make in dividend investing: chasing yield.
Low rates have driven people into anything with a decent payout. Such high yields, however, stretch companies to their limits. Like a ticking bomb, it’s only a matter of time before these dividends get cut.
Take telecom-provider Frontier Communications Corp (NASDAQ:FTR), for instance. In March, I warned readers that the stock’s 21% dividend yield would likely get cut. Sure enough, the company slashed its payout by more than half this month, and shares have plunged 55%.
For investors, we can take away three lessons here.
First, watch spending. Many firms scrimp on maintenance to milk their businesses for extra cash. You can think of it as burning the furniture to heat the house.
Frontier’s rural telecom network requires lots of ongoing spending to keep it in tip-top shape. But to keep sending out oversized dividend checks, management cut costs to the bone. This resulted in lousy service, angry customers, and falling profits.
Second, watch debt. Executives can paper over any problem by borrowing money. At some point, however, you can’t keep up with payments to both lenders and shareholders.
Here, too, Frontier’s numbers should’ve set off alarm bells. Management has stretched the balance sheet to the breaking point, with $3.60 in debt for each dollar in equity. Credit rating agency Moody’s Corporation (NYSE:MCO) called Frontier’s policy “aggressive” (the polite way of saying “reckless”) and downgraded the firm’s debt to “non-investment grade” (the polite way of saying “junk”). (Source: “Moody’s downgrades Frontier to B1, outlook negative,” Moody’s Corporation, November 7, 2016.)
Finally, watch cash flow. You need real profits to pay a dividend. If your company sends out more in distributions than it makes in cash flow, start looking for the exits.
You could see this problem clear as day at Frontier. In 2016, management paid out $707.0 million in dividends. The business, though, generated only $265.0 million in free cash flow.
Needless to say, this dividend time bomb finally went off. Last month, executives slashed the quarterly distribution by two-thirds to $0.04 per share. Worse, owners hoping for a big payout now sit on big losses. (Source: “Frontier Communications Corporation Declares Second-Quarter Dividends,” Frontier Communications Corp, May 2, 2017.)
Chart courtesy of StockCharts.com
This could just be the beginning. Even after the dividend cut, Frontier still pays out more than it earns. The distribution will likely get slashed again in the months ahead.
That said, I like the move. With less cash going out the door, management will have more money to pay down debt. It will also free up more funds to invest in the business—cash desperately needed to stem losses.
Bottom line: don’t chase yield. Any time you see a payout get this high, you’re probably looking at a dividend time bomb. And, while those 20%+ yields look tempting, the clock is ticking on those distributions.