If you have been struggling to generate enough income from your investment portfolio lately, then dividend stocks have been just about the best way to get the cold, hard cash you need. But before you simply accept the conventional wisdom about why dividend stocks are superior to other types of investments, you should keep in mind that in certain circumstances, dividends have almost nothing to do with the fundamentals of a business.
Why investors love dividend stocks
In general, there’s good reason for investors to gravitate toward dividend stocks. Historically, stocks that pay dividends have had better performance than their non-dividend-paying counterparts. One possible reason for dividend stocks’ outperformance is the simple fact that most stocks that pay dividends have cash-generating businesses backing those payments, with the most successful dividend payers having particularly stable free cash flow to finance payouts.
But just because solid businesses tend to produce lucrative dividends doesn’t mean that companies that pay lucrative dividends all have solid businesses. Let’s take a look at two situations in which dividend stocks can be downright dangerous.
Case 1: A deteriorating business
Often, a stock that used to be a solid dividend payer runs into tough times. For temporary problems, most mature companies can ride out the tough times without making dividend cuts. But when the situation gets dire, sometimes a dividend cut is the only alternative.
We’ve seen an increasing number of those situations lately. Cliffs Natural Resources Inc (NYSE:CLF) , for instance, slashed its dividend by three-quarters after realizing that the slump in iron ore and metallurgical coal prices simply wasn’t going to end soon enough for the company to sustain its payout to shareholders. The dividend cut helped Cliffs Natural Resources Inc (NYSE:CLF) conserve cash, but low prices have also led to some key moves for its underlying business, including the idling of production plants that will further hurt its revenue.
Case 2: Artificially high payouts
In other situations, dividend stocks make payouts that aren’t based on earnings or other income at all. Rather, they seem manufactured simply to appeal to income-hungry investors.