For some stock investors, dividends are the holy grail. Five percent yield? Great… especially compared to what you can get in a bank account.

But dividends can be a terrible guide. And focusing on 5 percent of the value of your capital – that is, the share price of the stock that’s paying you 5 percent – can be like swerving to avoid the squirrel running across the road… right into the path of an oncoming Mac truck.

That’s because a company’s ability to sustain its dividends depends on several factors: its earnings, its ability to generate enough free cash flow and its level of debt. These factors can change dramatically year over year, quarter over quarter.

And – this is the dangerous part – what happens if the share price drops? Just because a company can continue to pay a dividend doesn’t mean it’s growing. And that can spell trouble for a share price… trouble that can rapidly erase that 5 percent return from yield.

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Do you buy stocks for income?

Dividends are often compared to the risk-free rate of return – that is, the yield on a government issued fixed-income security, like a bond or treasury. (It’s called a risk-free rate because, theoretically, government-issued debt carries no risk of loss. It will be paid no matter what.)

In December 2008, the world’s central banks embarked on an unprecedented scale of quantitative easing – the process where they deliberately increased money supply to drive down interest rates. As a result, yields on traditionally safe government bonds have yet to recover to their pre-crisis levels.

In the U.S., even with the Federal Reserve hiking rates, the yield on the benchmark 10-year Treasury (at 2.7 percent) is still well below the 4 percent level before the global financial crisis in 2008-2009.

Yields elsewhere are low. In Switzerland, Japan and Germany, yields on many shorter-term treasuries are negative. US$7.9 trillion worth of bonds globally are still yielding negative returns.

This is why more investors are looking to dividend-paying stocks as a source of safe, reliable income. But they’re in danger of making the mistake of overlooking the important factors that drive dividends. It’s a recipe for disaster.

Your capital could be at risk

For example…

China Mobile (Exchange: New York; ticker: CHL) is China’s dominant mobile services provider, with 902 million subscribers. That’s three times more subscribers than AT&T (Exchange: New York; ticker: T) and Verizon Wireless (Exchange: New York; ticker: VZ) – combined.

Five years ago, China Mobile’s stock price was US$47.85. It was considered a mature, stable business, and it paid out US$2.26 in dividends that year. That was equivalent to a hefty 4.7 percent yield.

Today, the stock is selling for US$52.26. That’s a 9.2 percent capital gain.

Including the US$9.67 in total dividends paid over the period, the total return – had you bought shares five years ago – would be 29.4 percent.

But it’s important to note that China Mobile’s earnings have actually declined by 17 percent over the last five years, from US$5.10 per share in 2012 to US$4.23 in 2017. And as earnings fell, so did the dividend.

Based on last year’s dividend payout of US$1.87, someone who purchased China Mobile five years ago expecting a 4.7 percent dividend now has to settle for just 3.9 percent.

What this means is China Mobile’s stock had become more expensive over the years. From a price-to-earnings (P/E) ratio of just 9.4 times, China Mobile is now trading for 12.3 times P/E. (The price-to-earnings ratio is a common valuation used to determine the value of the share price relative to its earnings.)

An investor who bought China Mobile stock five years ago would have a respectable five-year return not because the business did well, but because its P/E ratio went up in the face of declining earnings. This is unsustainable. P/E ratios can’t go up indefinitely, especially when a company’s growth profile doesn’t support a higher valuation.

Had China Mobile’s P/E stayed the same, the shares would today be worth US$39.76 instead of US$52.26. Investors would have lost 17 percent of their capital, while pocketing 20.2 percent from dividends – for a total return of just 3.2 percent.

This means investors looking to buy China Mobile for its yield have had to rely on the shares becoming more expensive (on a valuation basis) in order to realise higher returns. That may work if the yield’s difference to the risk-free rate is large enough. But the more China Mobile cuts its dividends, the less investors will be willing to own it.

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Growth matters

As I said, China Mobile’s earnings have declined in four out of the last five years. The only reason is has delivered better than U.S. Treasury returns is because its P/E ratio has risen and made up the difference – making its valuation more expensive.

That doesn’t mean China Mobile can’t continue rising, and its P/E ratio won’t hit (say) 15 times.

But that would rely heavily on the company being able to maintain its dividend yield. That’s a tall order given that earnings have been on a downward trend.

If it doesn’t maintain its yield, the P/E ratio must adjust lower, along with the share price.

We’re seeing a similar situation in U.S. blue chip Johnson & Johnson (Exchange: New York; ticker: JNJ).

JNJ grew earnings less than 1 percent per year over the last three years, but has increased its dividends by 6.3 percent per year. Meanwhile, its P/E ratio has risen from 18.7 times to 23.4 times today.

So buying JNJ today for its dividend (which is still a respectable 2.7 percent) is exposing your capital to risk.

In short, you shouldn’t buy stocks for dividends alone.

Unless you’re a value investor looking for mispriced assets, growth in earnings should always be a key element in your stock investment decision making process.

Good investing,

Brian Tycangco
Editor, Stansberry Pacific Research