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Stock Watch

4 Dividend Stocks to Avoid

A generous distribution is not always a good thing. We highlight potential pitfalls that can derail your pursuit of income.

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What’s not to like about dividends? Income-seeking investors have flocked to them in recent years as interest rates have plunged. So have investors worried about an aging bull market and those seeking a buffer from volatility; they want to hunker down with dividend payers for the cushion they provide in downturns and for the way they seem to skirt the worst of the market’s mood swings.

See Also: 12 Stocks to Get Dividends Every Month

Those are all valid reasons to shop at Yields R Us. But not all dividend stocks are alike. Many of the so-called bond proxies to which investors have turned for income, such as utilities, telecommunication companies, real estate investment trusts (REITs) and companies that make essential consumer goods, are now way overpriced. A lot of them will get whacked when interest rates move higher—in fact, many of them took a licking in the first half of 2015. And some have little to recommend them, apart from their dividends.

In fact, says John Bailer, senior portfolio manager at The Boston Company Asset Management, you might consider some dividend payers wolves in sheep’s clothing. They pose hidden risks to your portfolio, particularly if you’re as interested in stock-price gains as you are in an income stream. Among the lurking dangers:

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Danger #1: Price

No matter how you slice it, bond proxies are expensive relative to historical norms. For example, the median price-earnings ratio for the highest-yielding stocks in Standard & Poor’s 500-stock index was recently 2% higher than that of companies with the fastest-growing dividends. Normally, the P/E of high-yielders is 12% below that of the stocks with the fastest-growing dividends. The least volatile stocks (a group dominated by dividend payers) recently traded at roughly 1.5 times the average P/E of the jumpiest stocks. Normally, there’s little difference in P/Es.

The story is the same if you look at companies by sector. Stocks of companies that make consumer necessities are commanding P/Es that are 8% higher on average than the premium P/E they’re typically accorded, says the S&P’s chief strategist, Sam Stovall. Utilities are even more expensive, despite this year’s decline. The P/Es of stocks in the slow-growing utilities sector are normally 18% less than the S&P 500’s P/E, says Stovall. Now, the discount is a mere 3%. “People should not yield to temptation by looking to dividends alone,” quips Stovall.

Overpriced dividend stock to avoid: The Clorox Co. (symbol CLX, $116.15) yields 2.7% but trades at 24 times estimated earnings of $4.82 per share for the fiscal year that ends in June 2016. S&P analysts say a P/E of 21.5 times is more realistic for the consumer-goods company. That would put the stock price at $104, down 10% from the current level, sometime within the next 12 months. (Share prices and related figures are as of August 19.)

Danger #2: Limited growth

When the economy is growing, you want to benefit from the upswing. “If you think the economy is going to accelerate, as we’re expecting, money will flow into industrials, tech and companies that make nonessential consumer goods, and people will hide less in consumer staples and utilities,” says Wells Fargo global stock strategist Scott Wren. This year, utilities and consumer staples stocks are projected to log earnings growth of just 1.2% and 2.7%, on average, respectively—among the lowest of all S&P sectors, with the notable exception of the beleaguered energy group, which is seeing declining profits. You don’t have to forgo dividends in order to migrate to faster-growing, economy-sensitive stocks, you just have be willing to make dividend growth a higher priority than dividend yield. Bailer points out that S&P 500 stocks in the financial and technology sectors have logged average dividend growth of 30% annualized over the past three years.

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Low-growth dividend stock to avoid: This may surprise you, because Procter & Gamble (PG, $74.12) has been paying dividends since 1890. By all means, if you own stock in this consumer giant, known for brands ranging from Tide to Pampers, keep cashing those dividend checks. But you might find better potential share-price gains elsewhere. Despite P&G’s plans to jettison some 100 brands, it will remain a plodding multinational behemoth, generating nearly $80 billion in annual sales. Dividend growth is slowing, too. The company’s recent 3% hike is far less than the annualized hikes of 6.6% over the past five years. Analysts at UBS Securities are lukewarm on the stock, rating it “neutral.” After years of subpar performance, P&G still faces challenges, and the turnaround will be slow, says UBS. And the strong dollar won’t help matters.

Danger #3: Rate sensitivity

When interest rates rise, the dividend wolves shed their sheep’s clothing and can be seen for the risks that they are. In other words, bond proxies act like bonds, and that means they fall in price as rates rise. We’ve already seen a preview: From late May 2013 through December of that year, yields on 10-year Treasury bonds rose from 1.6% to more than 3%—a debacle nicknamed the “taper tantrum” because it began when then-Federal Reserve chairman Ben Bernanke signaled the end of the Fed’s bond-buying program. During that period, a basket of bond proxies tracked by The Boston Company—consisting of utilities (mainly gas and electrics), telecom and staples stocks—fell 5% as the S&P rose 17%. Earlier this year, when the yields of the 10-year Treasury jumped from less than 1.7% in late January to 2.3% in late June, the basket of bond proxies fell 4%, and the S&P rose 4%. Over the same period, the Dow Jones Equity REIT Index fell 14%.

Rate-sensitive stock to avoid: It’s hard to think of a more interest-rate-sensitive stock than Annaly Capital (NLY, $10.44), a REIT that invests primarily in mortgage-backed securities. Annaly, currently yielding 11.5%, makes money by pocketing the difference between the interest income generated by the longer-term securities it owns and the shorter-term borrowing costs to buy them. When the Fed raises short-term rates—Kiplinger’s expects the central bank to hike short-term rates in September—it will wreak havoc with the company’s interest income, the main driver of profits. Annaly is more at risk than other mortgage REITs, says Daniel Altscher at FBR Capital Markets, because it doesn’t hedge against fluctuations in interest rates as much as its peers do. Altscher figures that just a 0.25 percentage-point increase in short-term interest rates could knock annual earnings down by 8%.

Danger #4: Fundamental hurdles

Dividend investors shouldn’t let a generous dividend blind them to industrywide or company-specific challenges that could trip up their stocks. For many multinational consumer-products companies that sell their goods overseas, for example, that could be the strong dollar. Electric utility stocks will struggle to maintain growth, says Bailer, as customers turn to solar and wind-generated power, or employ smart thermostats to conserve energy.

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Struggling dividend stock to avoid: GlaxoSmithKline (GSK, $43.30). The British pharmaceuticals giant is beginning to face stiff generic competition for its blockbuster respiratory drug, Advair, which accounts for 16% of sales; other respiratory therapies and a promising vaccine business have been slow to develop. The stock yields 5.5%, but if Glaxo continues to make such generous payments, its dividends threaten to swallow all of the company’s free cash flow. Even though the stock has retreated 25% since early 2014, it still looks expensive, given Glaxo’s deteriorating growth prospects, say analysts at Mirabaud, a London-based stock research firm.