Don’t Chase Dividend Yields – Grow Your Yield on Cost Each Year

Yesterday I got an email from a reader who was impressed with my argument for investing in dividend-paying companies.

He had found one that looked good:

I found another stock named Energy Transfer (NYSE: ET). After analyzing the stock, I found that ET pays a quarterly dividend of CLOSE TO $2!!! Besides, the stock price now is pretty low as it is near $6 while the highest during this pandemic was around $9.30. I expect it to drop further in price too. I wrote this email to you guys to ask for your opinion on investing in ET stock. It could possibly make me about at least $2 per share and around $1.80 per share for dividends. If I buy 1,000 shares of this, it can make me $2,000 + $1,800 = $3,800!!!

Before I opine on this “opportunity,” let’s be clear: This company’s quarterly dividend isn’t anywhere close to $2. Its last announced quarterly dividend was $0.305. So potential dividend earnings for the full year on 1,000 shares are $1,220.

Still, that’s a forward dividend yield of over 22%!

But for that actually to happen you’d have to be very lucky indeed.

I hate to disappoint my reader, but Energy Transfer is a perfect example of “yield chasing.”

That’s when an investor is attracted to a company because the dividend yield figure quoted on financial websites is unusually high.

Yield chasing is probably the most common mistake income investors make.

That’s because those who chase yield have got it exactly backwards.

Climbing Mount Yield Without Oxygen

The average dividend yield on the S&P 500 Index right now is about 1.75%.

Of those 500 stocks, 60 paid dividends just above 5%. Another 60 yield 6% to 7%, while 16 offer 8% to 9%. Only six pay over 10%.

Most analysts consider a 4% annual yield to be “high.”

Companies can produce yields significantly above that in one of three ways:

• The first is to be some form of pass-through vehicle, like a real estate investment trust or a master limited partnership. By law, these companies pay no corporate income tax, but they have to pay out 90% of their income as dividends. The recipients of those dividends pay tax on them. This allows these companies to offer yields a few points higher than normal corporations.
• The second is to raise dividends rapidly. But that attracts new investors who bid up the price of the stock, which pushes the yield back down again.
• The third way is to maintain previous levels of dividend payouts when the company’s stock price plummets. A $100 stock that pays a $5 annual dividend yields 5%. If that company’s price falls to $50, that yield is now 10%.

This last point illustrates the most important thing to understand about dividend yields: The company sets the dividend, but the market sets the yield.

That’s because yield is by definition the most recent dividend payment, annualized, as a percentage of the current stock price.

A company’s management can decide to maintain a dividend even when its stock price is falling rapidly.

But that’s like a mountain climber ascending Mount Everest without oxygen. You can try, but statistically, you’re probably not going to make it.

A Classic Yield Chaser Trap

Energy Transfer is a perfect example of this.

The company operates natural gas pipelines, including the controversial Dakota Access Pipeline. These pipelines are like toll roads. Natural gas frackers have to pay that toll to get their wares to market.

When times are good, pipeline companies like Energy Transfer build more pipelines so they can charge more tolls and raise more revenue. They do that by raising debt.

But if the demand for energy falls, energy producers reduce their output. The tolls dry up. Pipeline revenues plummet.

But loans still have to be paid. Pipelines still have to be maintained. The result is a decline in the pipeline operator’s free cash flow.

That presents their management with a choice.

They can cut the dividend to service their debts and protect their cash position.

Or they can try to maintain the dividend by cutting investments and operating costs, and dipping into capital reserves.

The market knows this. ET has fallen by almost 60% since the beginning of the year. But unlike most other pipeline operators, that have cut or even suspended dividends, Energy Transfer has chosen to try to maintain its dividend.

The result is a yield chart that looks like this:

In other words, a company that has consistently paid a dividend of between 8% and 10% is suddenly paying more than 20%.

Ask yourself: if Energy Transfer could consistently pay a dividend like that, why didn’t it do so before?

Here’s why:

The bottom line is that Energy Transfer is a company in distress. A dividend cut is highly likely.

Let Yield Chase You

As we have argued in several recent Bauman Daily articles, including one from Clint Lee here and one from me here, the key to profiting from income-producing stocks is to buy dividend payers with solid fundamentals at low price points, reinvest those dividends and allow your yield on cost (YOC) to grow over time.

Growing YOC like that is having yield chase you, not the other way around.

There are very few circumstances where a dividend yield in excess of 10% is sustainable. That doesn’t mean you shouldn’t try to lock it in … but the company has to have strong fundamentals. Energy Transfer doesn’t.

So the next time you analyze a dividend-paying stock for potential investment, make sure you do more than just look at the current published yield!

Kind Regards,

Ted Bauman

Editor, The Bauman Letter