Not All Dividend Yields Are Created Equal

by: , Managing Director and Senior Portfolio Manager, MainStay Investments

Generating income from dividend-paying stocks has been a tried and true investment strategy for generations. But, it’s important to know that not all dividend-paying companies are alike. Companies that pay the highest dividends may subject investors to greater risks. Following are strategies to use to identify what we believe to be the best sources of yield for your investment portfolio:

Look Under the Hood

While a high dividend yield by itself may be attractive, it’s sometimes an indicator of financial strain or impending volatility. As such, it’s important to take a thorough look at corporate fundamentals, the competitive landscape, industry dynamics, and the economic backdrop. In the case of stocks offering high yields, determine whether the issuer generates free cash flow, as well as management’s intentions regarding allocation of future cash flows. For example, are they likely to continue offering a high dividend, or could they be considering other uses, such as capital expansion or acquisitions?

Check for Sustainability

To estimate the sustainability of a dividend stream, you must first understand the sources of the cash used to fund it. More specifically, what’s driving a company’s cash flow, and how enduring are those drivers likely to be in the future? In addition, are policies in place to prioritize dividend distributions over other potential uses of cash? Maintenance of a reasonable cash balance above the dividend payout should provide some comfort that future payouts will continue.

Watch for Warning Signs

There are several indicators that a company may be vulnerable to reducing or eliminating its dividend. In addition to distributions made from unsustainable sources (i.e., asset sales or debt issuance), the company may have a weak balance sheet or capital allocation policies that don’t clearly establish the return of cash to shareholders as being a priority. Dividend payments may also be a victim of exogenous factors, including regulatory pressures or reduced access to capital markets during periods of stress.

What Does a Company’s Stock Price Say?

It’s tempting to look at the stock price of a company with a high dividend payment to gauge if the payout is sustainable. But, looking at a stock price in a vacuum may be deceiving. If the price is declining due to a significant issue affecting its ongoing business, it would be a concern. However, sometimes stock prices fall in response to headline news that doesn’t have a material impact on a company’s fundamentals. In other cases, a company’s shares may be dragged down by a general market pullback, such as what occurred during the market correction in mid-February 2018. In such instances, price declines may represent a more attractive valuation for prospective buyers.

Historically Attractive Sectors

Companies that tend to be more sensitive to swings in the economy generally see more volatility in their cash flows and, therefore, have less predictability in their dividend streams. In contrast, companies in defensive sectors—such as consumer staples, utilities, and health care—typically enjoy more stable cash flow patterns and frequently provide more reliable dividend distributions.

Source: Bloomberg, as of 5/2/18. Current Dividend Yield from the S&P 500 Index GICS (Global Industry Classification Standard) Sectors. Past performance is not indicative of future results. It is not possible to invest in an index.

Conclusions

Buying securities based on yield alone is a practice fraught with peril. A more prudent approach is to conduct a thorough analysis of a company’s underlying fundamentals. In addition, it’s important to understand the business activities that led to a company’s distribution patterns, along with their commitment to maintain their payouts in the future.

Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.

About Risk

All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.

Dividends fluctuate and are subject to change. There is no guarantee they will continue to be paid. While dividends may cushion returns in down markets, investments are still subject to loss of principal amount invested.

Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.

Actively managed strategies employ portfolio managers who decide, within the constraints of a prospectus, how assets are invested. For this service, actively managed strategies typically charge higher fees than unmanaged or passively managed strategies.

The Standard & Poor’s 500 Index (S&P 500) is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion and is seen as a leading indicator of U.S. equities and a reflection of the performance of the large-cap universe.

New York Life Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Jonathan Swaney

Managing Director and Senior Portfolio Manager, MainStay Investments

Jon is a Managing Director and Senior Portfolio Manager in the Strategic Asset Allocation & Solutions Group.  His current focus is on management of the MainStay and third party asset allocation strategies

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