So, you’ve built a healthy portfolio.
You have some precious metals.
You have diversified across several economic sectors.
You have a core set of U.S. Treasury bonds – held via an ETF.
And of course: You have a good set of bellwether stocks in the middle of your portfolio that reliably pay a dividend.
You shouldn’t underestimate that last part. According to Moody’s, investors who hold dividend stocks earn more than 55% more over an average 10-year period compared to investors whose profit is based on growing stock prices alone.
That’s great news for the risk-averse. And it’s impressive when you consider how much focus most investment commentators put on growth stocks – especially tech growth stocks.
But one question many investors fail to ask is: What’s driving the dividend payouts? Is a company funding those payouts to shareholders with sales and profits, or with debt?
It’s a key question. Especially in an era of near-zero interest rates. Remember, the cost of borrowing is so low, many companies are raising extra cash through low-interest loans or by issuing new bonds.
Investors should remain wary of companies where the only mechanism to fund dividends is via debt. Believe it or not, that does happen.
Let’s take one case study as an example: Harbor Freight Tools is a midsized retailer of tools and construction equipment. It’s a beefed-up version of the hand and power tools section of a Home Depot or Lowe’s.
Last week, the company announced it would raise $3 billion in loans. It would use the proceeds to refinance previous debt and fund its 2020 dividend payout.
In Wall Street jargon, this type of loan is called “dividend recapitalization.” According to the Federal Reserve Bank of New York, publicly traded firms tallied over $12.1 billion of this type of loan in September this year. That’s the highest level for any month since 2014.
At that rate, Wall Street will leverage more than $150 billion in loans to fund dividends to investors over the next year. That’s more than 20% of total dividends paid to investors for the year.
That number alone should be sobering. If dividends are paid out of a company’s profits or a cash war chest, that’s sustainable. It’s a sign the company is likelier to reliably pay out future dividends.
Continuing the Harbor Freight Tools example, the company has used dividend recapitalization several times since 2010, with loans in 2010, 2012, 2013, and 2016. Since 2010, more than 180 Fortune 500 companies have engaged in some level of dividend recapitalization. That’s not surprising given the sub-3%-interest-rate environment we’ve all become used to operating in since the Great Recession rate cuts in 2009.
So, to sum up, as an investor with a yield-producing portfolio, one way to shore up future capital gains is to look at your dividend-paying stocks to see how they source their dividends each year.
If their primary source of cash for payouts is loans, it might be time to look at other companies. Especially companies that can fund payouts through profits and efficient operations, rather than purely from low-interest loans.