What I Wish I Knew Before Investing In Dividend Stocks
  • Dividend investing has been very rewarding for me.
  • However, I have learned a lot of lessons the hard way.
  • I share some of the most important lessons I have learned in this article.

As someone who has employed a focus on dividend investing for the vast majority of my investing career, I have been blessed with a lot of success along the way, including significant outperformance in the broader market and an ever-growing stream of passive income. That said, while I have had my share of successes, I have also had at least my fair share of failures and, as a result, have learned a lot of lessons the hard way. One mistake I have made several times in the past and that I see a lot of investors that I deal with on Seeking Alpha and elsewhere make is improperly taking into account a dividend stock’s track record.

In this article, I will discuss some of the ways that investors often misapply a company’s track record to analyze whether or not it makes a good dividend investment and share some lessons that I have learned on how to properly do so.

Lesson #1

One of the biggest mistakes I have seen is investors simply looking at a company’s total return track record and assuming that if it has delivered significant total return outperformance over time, especially in recent years, then therefore it makes for a great investment. I wish investing were that easy. After all, if it was as simple as looking at a stock chart, why don’t we just all buy Bitcoin (BTC-USD , Nvidia (NVDA , Tesla (TSLA , and maybe a few other high-flying stocks and call it a day, and we will all be rich within a few short years.

However, as the famous saying goes, “past returns do not guarantee future results.” The market is a forward-looking instrument, so just because a company has delivered exceptional growth in the past, which has resulted in strong price performance, it does not in any way guarantee that it is going to continue to do so moving forward. After all, that growth is typically priced in to the stock, and therefore the company will have to outperform current expectations priced in the stock in order for the company to continue to deliver continued outperformance. The more bullish the market gets on a stock, the harder and harder that gets to do.

Lesson #2

Another mistake that I see a lot of investors make is that just because a company has delivered exceptional dividend growth in the past, they assume that it will continue to do so in the future. This is a more reliable metric than total return performance in recent years, when analyzing a dividend growth stock because dividends tend to be much more consistent and dependable than stock price performance, and a company that has proven to be committed to dividend growth in the past is much more likely to continue to do so moving forward than one that has a poor track record of consistent and strong dividend growth. However, there is no guarantee because ultimately, at the end of the day, dividends, and especially dividend growth, are constrained by the strength of the company’s earnings stream, its continued ability to grow its cash flows, and ultimately, its balance sheet strength.

finviz dynamic chart for AQN

An example where I made this mistake was with the utility (XLU Algonquin Power & Utilities (AQN . They had an impressive track record of about a decade of growing their dividend at about a 10% rate per year while also paying out an attractive dividend yield. On the surface, things seemed fine as the company had a BBB credit rating, generated stable cash flows from its regular utility, and highly contracted renewable power assets, and it had a large acquisition lined up that was supposed to be very accretive to earnings.

However, under the surface, what I failed to see was how much exposure they had to floating interest rates as well as the need to raise equity at a time when interest rates were just about to take off and their balance sheet was already quite heavily leveraged for a BBB credit rating. As a result, the company’s dividend growth streak blew up, and not only that, but it then had to slash its dividend quite steeply multiple times in the coming years, leading to huge losses for investors. While I managed to navigate the situation to mitigate some of the losses, I was still left with a bloody nose, and it turned out to be one of my worst investments over the past five years.

finviz dynamic chart for XIFR

Another example of this is NextEra Energy Partners (XIFR . This is a renewable yieldco that also seemed to have a lot going for it, as it had a tremendous track record of growing its distribution at a double-digit annualized rate quarter after quarter, and delivered strong total returns along the way. It had a business model of raising equity and debt to acquire drop-downs from its world-class utility parent, NextEra Energy (NEE , to regularly grow its cash flow stream, backed by long-term power purchase agreements to investment-grade counterparties. Then, with the excess cash flows that were coming in, returning that to unitholders through the steadily climbing distribution.

However, once again, while on the surface the track record looked great, and even the business model and balance sheet appeared fine, digging under the surface revealed that the company had taken on enormous debt and equity obligations that would need to be repaid. Unfortunately for them, these obligations were taken on in an era of extremely low interest rates and would need to be repaid in a period following a significant rise in interest rates, creating a terrible bind for the company. It has already resulted in distribution growth slowing and is very likely to result in a steep distribution cut in the very near future. In the process, unit holders have gotten burned with severe losses.

Lesson #3

That said, while it is very easy to overrate a company based on its dividend growth track record, it is also very easy to underrate a company based on its recent track record, including a track record of distribution cuts. An example of this is Energy Transfer (ET , which was in the doghouse with a lot of investors following the 50% cut of its distribution in late 2020. The reason many did not like this move is that midstream MLPs (AMLP are primarily income vehicles, and if they cut their distribution, it makes them very unattractive to investors. That is certainly a fair argument to put ET in the penalty box moving forward because of that, but this was simply a misunderstanding of the company’s situation at the time. ET was extremely unfortunate, as they had invested aggressively—perhaps slightly too aggressively—in growth projects at a period shortly before the COVID-19 outbreak occurred. As a result, they were in a position where they had a lot of capital expenditures without a lot of corresponding EBITDA coming in, and the energy sector was suddenly faced with record-low commodity pricing and an uncertain future.

As a result, ET decided to be very conservative and retain more cash flow to pay down debt as fast as possible in order to ensure that its investment-grade credit rating was preserved. And then, once it got its leverage under control, got through its heavy CapEx cycle, and more EBITDA began coming online, it would restore its distribution to its pre-cut level. Sure, other companies that took a more conservative approach with their CapEx, such as Enterprise Products Partners (EPD , got through that period just fine and continued to grow their distribution year after year. I would even agree that a cut to a distribution for a midstream MLP is almost always a negative thing. However, I think that ET was penalized far too harshly because the underlying fundamentals of the business still remained fairly resilient, and the company could have continued to pay its distribution on a cash flow basis, but they simply wanted to preserve their investment-grade credit rating because, once lost, it is much harder to get back.

ET has since executed on its commitments very well by paying down debt and deleveraging its balance sheet, and today its distribution is above where it was on a pre-cut basis and is continuing to grow. Meanwhile, ET’s unit price has soared higher, making it an exceptional investment for those who bought it after the distribution cut crashed its unit price. The lesson here is that just because a company has cut its dividend recently does not mean that a dividend investor, even a dividend growth investor, should run from it. Instead, they should look at the underlying cause and fundamentals of the business and determine if this is simply a strategic short-term move or if it is symptomatic of an ongoing underlying problem with the business.

Lesson #4

Finally, a more complicated example of this is the triple net lease REIT (VNQ Realty Income (O . Looking at the long-term chart for O reveals that it has been one of the most exceptional REITs and dividend growth stocks of the past 30 years, as it has grown its dividend remarkably consistently over that very long period of time despite all sorts of economic and technological disruptions and changes.

Chart
Data by YCharts

It has also delivered exceptional total returns over that period and has built out one of the largest and most respected real estate empires over that time, while also establishing a stellar A- credit rating that reflects the strength of its financial position. However, in recent years, the stock has delivered underwhelming total return performance, especially compared to some of its smaller triple-net leased peers like Agree Realty (ADC and Essential Properties Realty Trust (EPRT .

Chart
Data by YCharts

As a result, many investors are now rejecting O and saying that it is “dead money” and a bad investment and mismanaged because of this.

However, they are ignoring several factors when judging O based on its recent returns. First of all, the dates that they are hearkening back to are ones where O was priced at a very rich premium because of its impressive track record of growth and total returns up until that point, meaning that it would be harder for it to sustain those kinds of total returns moving forward because of valuation multiple expansion. Additionally, the company had gotten really large to a point where its growth was likely going to slow along with rising interest rates in recent years and the rich valuation that it traded at, which meant that it was paying out a lower dividend yield than some of its smaller peers. As a result, it was very unlikely to continue delivering exceptional total returns moving forward, so recent results should not be surprising.

However, when looking at O now, investors need to take into account, especially when comparing it to peers like ADC and EPRT, that O trades at a meaningful price-to-FFO discount to them, as well as a higher dividend yield. Yes, it may still grow more slowly than those smaller peers, but its dividend yield and discounted valuation make up for that difference. Additionally, it is larger and more diversified, and in the case of being compared to EPRT, it is arguably a much higher quality and more defensive portfolio, which adds further weight in its favor. While certainly a case could be made for buying ADC or EPRT instead of O today, especially for those who value growth, I am simply pointing out that you cannot discredit O purely based on its recent underperformance without taking into account all these other factors. Otherwise, the analysis becomes oversimplified and does not consider all the other factors at play.

Investor Takeaway

As this article points out, dividend investing based solely on a company’s total return or dividend growth track record is often an oversimplified approach to investing in a business. Certainly, the track record does mean something, as it says a lot about management’s trustworthiness and commitment to the dividend, as well as its capital allocation and balance sheet management skills over time. However, when getting enthusiastic about a stock purely based on its track record or wanting to completely avoid a stock based exclusively on its recent results, it is important to look at the underlying factors involved that are driving total return, outperformance, underperformance, or strong dividend growth or even a dividend cut, and then proceed from there. There are times when companies that just cut their dividend actually end up being some of the greatest investment opportunities, whereas in some cases, companies that have an exceptional dividend growth track record are actually some of the worst investments that you can make at the time. This is why we focus on doing significant due diligence, company interviews, and rigorous valuation analysis of each dividend investing opportunity that comes our way at High Yield Investor.

Photo by Gilly on Unsplash

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