For decades, global investors have looked to dividend-paying stocks to generate both income and total return. In fact, research suggests that reinvested dividend payments contribute a substantial portion of equity market returns over the long term through the power of compounding. Moreover, given today’s compressed future return expectations and low real yields, the pressure is on for investors to focus more on generating income, even as the interest rate environment shifts. This is nothing new, as investors have faced persistent income concerns since the financial crisis ushered in an extended period of record-low rates.

Generally, dividend-paying companies exhibit strong balance sheets and a commitment to return profits to shareholders. But dividend investing is far from a sure thing. The prospect of rising interest rates, for example, can negatively impact bond-like equities such as utility and consumer staples stocks that offer relatively high dividends, but generally low expected earnings growth. Another risk may exist in companies with deteriorating fundamentals and too-good-to-be-true dividend payouts. With the likelihood of aggressive action by the Federal Reserve still small, and other central banks around the globe in various levels of modest tightening, investors may be more apt to focus on the underlying company fundamentals than concerns about rising rates.

Ferreting Out Dividend Traps

Stocks that boast appealing yields, but then cut payouts, or that have high “optical” yields because of quickly falling share prices, are commonly referred to as “dividend traps.” Investors who chase these higher yields without paying attention to fundamentals may assume greater risk and, in many cases, sacrifice total return. It’s similar to drawing straws: Just because a straw is sticking out of the pack doesn’t mean it’s the longest one in the bunch. Examining certain characteristics of higher-dividend stocks can help investors identify and avoid those with deteriorating fundamentals or other risk factors. One way is by looking for outliers such as companies with unusually high yields or companies with deteriorating fundamentals, high leverage, or extremely high or unsustainable dividend payouts versus peers.

For our analysis, we grouped constituents of the mid- and large-cap S&P 900 Index into quintiles based on dividend yields from 1991 to 2018. Quintile 1 represents the highest-dividend-yielding stocks, and Quintile 5, the lowest. Plotting these yield quintiles over a 27-year period shows the yield investors received for a given level of risk. Exhibit 1. Quintile 1 offers an attractive yield, but also has significantly higher risk versus the index. Meanwhile, Quintile 2 also has an above-index yield, but with only a moderately higher level of risk.

Exhibit 1: S&P 900 Index Dividend Payers by Quintile – Average Dividend Yield vs. Annualized Standard Deviation

For a more complete picture of these quintiles, we can examine total return versus risk. Exhibit 2. In this case, Quintile 2 offered both the highest total return and lowest risk of all quintiles. Interestingly, Quintile 1 combines high realized risk with lower total returns than Quintile 2, supporting the idea that the highest dividend yields may not make the most attractive investments.

Exhibit 2: S&P 900 Index Dividend Payers by Quintile – Annualized Total Return vs. Standard Deviation

What’s driving the risk of the highest dividend-paying stocks? Underlying fundamentals offer a clue. Exhibit 3 plots dividend payout ratios (the percent of net income paid out in dividends) against debt-to-equity ratios, which measure a company’s leverage. Quintile 1 stocks are paying out the highest level of dividends relative to net income, and have high levels of leverage. Again, Quintile 2 offers a more attractive picture with more moderate leverage and dividend payouts relative to income.

Exhibit 3: S&P 900 Index Dividend Payers by Quintile – Average Dividend Payout Ratio vs. Average Debt/Equity Ratio

Don’t Forget Fundamentals When Evaluating Dividends

They say you shouldn’t judge a book by its cover. That also applies to the highest dividend-paying stocks. While they may appear attractive on the surface, they can be dividend traps. By incorporating fundamentals into the analysis of dividend-paying stocks or dividend-focused strategies, it’s possible to find those that offer attractive yield and total return potential without undue risk.

The S&P 900 Index combines the S&P 500 and the S&P MidCap 400 to form an investable benchmark for the mid- to large-cap segment of the U.S. equity market.