Earnings Drama Grows as Dividend Seekers Put Stock in Payouts

Lately, when a company paying a pricey dividend announces earnings, there is drama. And while it usually has a happy ending, there are also a few tragedies and some pure comedies.

Such drama is a new experience for the income-seeking investors who have flooded into dividend stocks over the past year. After all, bonds, by comparison, are much more predictable in their coupon payments. But low yields mean investors are flooding into stocks, where inherent risks have not gone away.

Telecom company CenturyLink provided laughs last week (as long as you did not own the stock) by sharply lowering its dividend payout while increasing stock buybacks to $2 billion. The move backfired, and inspired a 26 percent one-day stock collapse. Rival Windstream, which fell 10 percent in reaction, was left to ease investors' fears that it would follow suit amid earnings pressures in the telecom sector that could hurt payouts.

"On the earnings call, the [Windstream] CEO said at least 10 times in the first 15 minutes that they were committed to the dividend," says Todd Rethemeier, a longtime telecom analyst with Hudson Square Research, who listened to the call.

He found the CenturyLink move a bit baffling. "It's a strange one, a real headscratcher," says Rethemeier. "I've never seen anything like this. It's funny if they thought they were going to get that one past investors."

[Read: The Outlook for Dividends in 2013.]

For investors, the episode also illustrates the risks of a dividend cut even when companies have lots of cash on hand. The market appeared stunned when the cash-generating, profitable telecom made the move, cutting its payout 25 percent but putting much more into the big stock buyback. "They could have afforded to pay the dividend," says Rethemeier. "They have the cash. If they had put $1 billion of it into holding the dividend and $1 billion into buying back stock, their share prices would have gone up."

Questionable corporate logic aside, the incident shows it's a tricky road for income investors. That's because not every high-dividend payer like CenturyLink can afford its payout, and investors should probably be wary when payouts rise over 5 percent in the telecom sector at large, analysts say. "It's not a hard rule, but it's just a level where you have to start to wonder why are they paying that much," Rethemeier says.

Telecoms are a favorite of high-dividend investors because they are cash-flow-driven companies that are becoming toll-takers on the information highway. Traditionally, the telephone companies made dividends a top priority in a heavily regulated sector that produced profits that were once virtually guaranteed, although big changes--the decline of the landline and the rise of mobile--are remaking a formerly reliable industry which paid dividends as steadily as utilities or tobacco companies.

[Read: The Anti-Gun Control Mutual Fund.]

Also, whatever troubles the telecoms might be having says little about the overall dividend environment, says Howard Silverblatt, senior index analyst at Standard & Poor's. "Last year was the most amazing year ever for dividends, and there will be more growth this year." Even after record payouts, he says, companies pay out an average of just 36 percent of their cash versus the historic average of 52 percent. The number of companies increasing dividends rose 94.5 percent from 2011. Silverblatt says last year's record payout of $280 billion by S&P 500 stocks should rise to another new high in 2013.

"There have been very few dividend cuts, companies still have tons of cash, and they are still relatively cheap," says Silverblatt.

Dividend funds were by far the biggest gainers over the past year in the equity space, accounting for most of the gains in inflows to equity funds, says Tom Roseen of Lipper. To be sure, those new investors will be carrying a lot of expectations into the new year, and any slipups in payouts like the one CenturyLink made will be punished.

For many, the best choice will be to spread risks across funds that invest in a range of companies and sectors. The WisdomTree Dividend ex-Financials Fund and the Schwab U.S. Dividend Equity ETF have gained 7 percent in net asset value this year and 14 percent over the past 12 months. They're U.S. News's top-rated Best Fit ETFs in the income category.

Still, there's a case to be made for anything offering yield these days, which bonds simply aren't. "Compared to 10-year treasuries paying 2 percent, these yields are attractive," says Brian Gendreau, market strategist for Cetera Financial Group. "You can do a spreadsheet and find thousands paying much more than that. And you can lose principle on bonds if rates go up. Dividend-paying companies increase their dividends when that happens. We are still recommending them."

[See 8 Top-Rated Income Funds.]

But the recent rise in stocks and the targeting of dividend payouts has the potential to lower yields in the short term. Investors hoping for more dividend income could be disappointed if increases fail to please, and Roseen says there are signs that investor enthusiasm is already waning. Inflows to equity income funds have leveled off and fund buyers have been moving into more non-income-driven corners of the market. Investors put $60 billion into equity and mixed asset funds in January, Lipper reports, making it the biggest month in seven years. Equity income made up just $2.5 billion of the total. Most of the new money went into growth, value, and international stocks. If that trend continues, some analysts see it as a healthy sign for the market as investors look to get more diversified.

"You have seen investors in a desperate search for yield with treasury yields as low as they are, says Hugh Johnson of Hugh Johnson Advisors. "Investors are turning in every direction to try to increase either divided or interest income in their portfolio. I don't want to call it mania quite yet, but it has all the earmarks of mania."

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