Investing in a huge, well-known company that's an industry leader and pays a nice dividend might seem like a no-brainer, especially if the stock looks reasonably priced. But like the famous George Gershwin song says, "It ain't necessarily so."
There's nothing wrong with using a company's size, reputation and basic valuation metrics as starting points for selecting high-quality, dividend-paying stocks, but there are plenty of other things to consider. To make my point, let me tell you about a popular dividend payer I would not recommend to income investors.
This giant in the global petrochemicals industry has annual revenue of $58.4 billion and operations in 160 countries. What's more, the stock has a 4.3% yield and price-to-earnings (P/E) ratio of 19, compared with the five-year average P/E ratio of 39.
Still, this stock isn't on my list of investment ideas for dividend seekers.
I'm referring to Dow Chemical Company (NYSE: DOW), which I see as a lot riskier than its dividend is worth. Here are several reasons why income investors should consider avoiding the stock:
1. Industry oversupply is a real threat.
Vast new chemical capacity has been coming online during the past few years, mainly in the Middle East and China, on the assumption that global economic growth would be faster than it has turned out to be. Dow Chemical has been working on a $20-billion, 50/50 joint venture with the Saudi Arabian Oil Co. to form Sadara Chemical Co., which is scheduled to open in 2015 and produce several million tons per year of many chemical and plastics products used in everything from aircrafts to medicine to adhesives.
What has analysts worried is oversupply in the chemical industry. They say for it to achieve healthy growth and profits, demand growth must outstrip supply expansion by at least 2% a year through 2015. This is a tall order since supply is growing 3% a year, while demand in the developed world is expected to mirror projected yearly GDP growth of 1.3% to 1.5%.
This means emerging markets have to pick up the slack, and I'm not sure they can. It seems doable now, since demand for petrochemical products has been rising 6% a year in emerging markets. But this growth rate could fall off if developing economies slow significantly, as many already seem to be doing.
2. The stock is highly cyclical and volatile.
Cyclical stocks are those whose fortunes are closely tied to the economy, and this describes Dow Chemical to a T. From the onset of the recession in 2007 to now, earnings per share shrank 12% annually, from $2.99 to $1.59.
The stock was absolutely crushed in 2008, the height of the financial crisis, dropping 57% while the overall market was down 37%. Since hitting bottom in 2009 below $10, the stock has recovered to the $30 area currently, but in the past five years, the per-share dividend has contracted 5% a year, dropping from $1.64 to $1.28. More of the same could be in store during the next three to five years if economic growth remains weak.
3. Debt is snowballing.
Dow Chemical's balance sheet is still under strain from the $9.2 billion of debt the company added April 1, 2009, when it completed its acquisition of rival chemical maker Rohm and Haas Company in a deal worth $16.2 billion (about $7 billion of which was financed with preferred stock). Now, management is seeking another $6.2 billion of debt financing from various sources to hold up Dow's end of the Sadara Chemical joint venture I mentioned earlier.
At this point, total debt is $20.6 billion, which is roughly equal to shareholder equity, and at a level analysts say is manageable for now. The company is pushing it, though, and might find it has overextended itself, particularly if the economy takes a turn for the worse.
Risks to Consider: In addition to the risks I've already described, Dow Chemical faces the likelihood of higher energy costs because of cap-and-trade legislation aimed at reducing greenhouse gas emissions.
Action to Take --> Income investors should avoid Dow Chemical. Since the stock has big disadvantages and the economic outlook is uncertain -- even gloomy -- a 4.3% yield just doesn't cut it.
Dividend seekers can easily get a similar or better yield from any number of much safer stocks. For instance, I'm a fan of Sysco Corp. (NYSE: SYY), AT&T Inc. (NYSE: T) and Kimberly-Clark Corp. (NYSE: KMB). These stocks currently yield 3.9%, 4.7% and 3.5%, respectively, they're not cyclical like Dow Chemical, and they all demonstrate much less price variability.