You hear this so often that it's now an investment cliché: There's safety in dividends. If share prices nosedive, dividends will cushion Mr. Market's blows. The truth is that dividends often aren't safe. They can even be dangerous, because they can give investors a false sense of security.
The most dramatic recent example is income trusts. Investors raced to those big-dividend-paying firms in the early 2000s. But there were noises for years that Ottawa would eliminate the tax advantages of the trust structure, and it did just that on Oct. 31, 2006. The prices of some trusts plunged by 20% or more, and many trusts had to slash their dividends.
Of course, dividends sometimes provide a cushion in bad times, but they can make a bad situation worse if the payouts are cut or eliminated. Exhibit A: Manulife Financial . In the early 2000s, the company sold annuities that allowed buyers to share in stock market gains, but also guaranteed benefits paid to them. At first, Manulife insured itself against the unlikely possibility of a major stock market collapse. But then it stopped buying the protection, a move that goosed its profits. Manulife also steadily increased its quarterly dividend from five cents a share in 2000 to 26 cents in 2008, attracting yield seekers.
After markets collapsed in 2008, the process reversed. Manulife's share price plunged, and it halved its dividend to conserve cash. The company also issued a lot of stock to shore up its balance sheet, diluting the value of existing shares. The lesson: Don't trust managers of even a blue chip company to maintain its dividend during bad times.
Tempted by a high dividend yield? Remember that yield is a sign of risk as well as reward. Last spring, Armtec Infrastructure , which makes products such as precast concrete and tubing, raised $60 million in an issue of shares priced at $16.20. The dividend was $1.60 a year—a 10% yield. But in June, Armtec reported a quarterly loss and suspended its dividend. The company's CEO later quit and the stock price, as of this writing, is under $2.
Armtec also had to seek an emergency loan from Brookfield Asset Management . Brookfield got a lot of warrants giving it rights to buy Armtec stock, which will dilute existing investors' holdings if and when the warrants are exercised. So much for safety.
Don't get me wrong: Dividends can be very lucrative. Historically, almost half of long-term stock returns have come not from capital gains, but from dividends. But you shouldn't blindly invest in a company only because it pays a hefty dividend.
You can protect yourself enormously by doing a little homework. First, just because a company has a history of paying a dividend doesn't mean it'll keep doing so. Corporations have a life cycle—many of them mature, decline and die. Remember Nortel.
Watch revenue and cash flow. Any declines are an alarm bell. A double-digit dividend yield is another screaming danger sign. If a company's yield is more than eight percentage points higher than that of a safe 10-year government bond, beware.
Finally, be extra skeptical about what managers and directors say about dividends. They hate cutting them, and they often wait until it's too late to do so. If you're still around when they finally do, your dividend will have cost you money.
Home Capital Group Inc. Forward price/earnings ratio: 7.1
Home Capital is the Canadian mortgage lender of choice for the self-employed, whose tax returns tend to understate their ability to pay and who are therefore shunned by banks. Buying Home Capital shares a decade ago would have helped pay off a mortgage by today. Given the company's consistent double-digit growth rate, the same may well hold true in future.
Edgewater Wireless Systems Inc. Amount raised in a private placement: $6.4 million
Problem: Mobile networks are being stressed by soaring smartphone use. Solution: Redirect traffic to WiFi, as AT&T is doing with more than 125,000 free hot spots. Next problem: Existing wireless technology has single-lane off-ramps, where Ferraris are stuck behind turnip trucks. Potential solution: Edgewater's multichannel units, which allow more free-flowing traffic. The Ottawa-based start-up's shares are scheduled to start trading in January.