Beware Feeble And Fading Aristocrats

Dividends: Beware Feeble And Fading Aristocrats

Using dividends as the primary stock-picking criterion is a good way to lose money. The value of a company is determined not by its payout policy, but by its fundamentals -- its ability to earn returns above its cost of capital and to generate free cash flow. Dividends are not necessarily a good indicator of these fundamentals. Many companies with poor fundamentals can afford to pay high dividends, at least for a while. Indeed, some firms, including quite a few utilities, are effectively financing their dividends not with internally generated funds, but rather by issuing new shares. High yields can be particularly deceptive, because they are lagging indicators. When the fundamentals of a company are deteriorating (think GE (GE) in 2008), corporate boards of directors are the last to know; as the stock price slides the dividend yield will rise, enticing investors until the board wakes up and belatedly slashes the dividend (think GE in 2009). One good example of the risk that comes from putting the dividend cart before the fundamentals horse is Standard & Poor's "Dividend Aristocrats" -- 51 stocks in the S&P 500 that have raised their dividend every year for at least the last 25 years.

... Bottom line: It is a mistake to simply invest in the Dividend Aristocrats Index (or an approximation thereof), because you will own too many weak, slow-growing companies while systematically avoiding attractive sectors such as technology and banks. It makes more sense to use the Aristocrats as a "shopping list," favoring those stocks that have fairly strong dividend and earnings growth, positive stock price momentum, dividend payout ratios below 60%, and rising consensus EPS estimates. To these should be added quite a few non-Aristocrats with strong fundamentals, decent yields of 2-4%, and rising dividends
Comment: A good place to "shop". The stated dividend amount and P/E ratio are backward looking and no guarantee of the future.

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