Buyer beware: why I’m wary of putting high-yielding dividend stocks in my ISA

I’m always looking for dividend stocks to include in my portfolio. But I always proceed with caution when I see a share with a very high yield.

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I’ve found that investing in dividend stocks is a great way of supplementing my income which doesn’t stretch as far as it once did, thanks to the cost-of-living crisis. But there’s little point buying a high-yielding stock if it’s in terminal decline. When it comes to picking winners, therefore, it’s a case of buyer beware.

Housing crash

Persimmon is a good example. The housebuilder has a reputation for paying generous dividends. The payout for 2021 was 235p per share. In March of that year, the company’s share price was over £32, giving a yield of 7%.

However, a downturn in the housing market caused its share price to tumble. By October 2022, the company’s stock was yielding 20.6%. Six months later, the directors cut the dividend to 60p. The shares now yield around 5%. This is still above the FTSE 100 average. But it’s a far cry from the figures being quoted towards the end of last year.

The apparently very high return offered by Persimmon’s stock was a warning that the company’s dividend was unsustainable.

What other high-yielding alternatives are there?

Digging and smoking

Historically, mining and tobacco companies have paid decent dividends.

For example, Glencore‘s stock is currently yielding close to 8%. However, its profits can be erratic due to volatile commodity prices. This means its dividends fluctuate from one year to the next. In good times it makes special (one-off) payments. But these are not repeated when earnings are lower.

Tobacco companies offer good returns to shareholders. Shares in Imperial Brands are currently yielding 7.5%. But the company’s dividend is now 30% lower than it was in 2019.

A better alternative might be British American Tobacco which has a higher yield (7.7%). Unlike its smaller rival, it has raised its payout to shareholders during each of the past four years.

I’ve no problem investing in smoking stocks, although I know some object on ethical grounds. My biggest concern is that governments around the world are placing increased restrictions on all types of tobacco products, including the newer so-called less risky variants. I fear this will reduce earnings — and therefore dividends — over the next few years.

Caution

Some companies pay the majority of their earnings in dividends instead of re-investing the cash in developing and growing their businesses. This produces eye-catching yields but, ultimately, could be self-destructive.

Last year, M&G paid dividends of £479m and completed £503m of share buybacks. Yet the company saw a net cash outflow from its operating activities. If sustained, this could be to the detriment of the company’s long-term growth prospects. However, its double-digit yield is alluring.

As consumers, we are often warned that if something looks too good to be true, then it probably is. That’s why I prefer less volatile dividend stocks like National Grid.

The owner of the UK’s electricity grid has been steadily increasing its dividend. Last year, it was 11% higher than in 2018. And it accounted for a conservative 39% of earnings. The stock should yield 4.7% this year. If funds permitted, I’d be happy to have this stock in my long-term portfolio.

I try not to be too greedy when it comes to choosing dividend stocks. Shares offering yields slightly above the FTSE 100 average are good enough for me.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Beard has positions in Persimmon Plc. The Motley Fool UK has recommended British American Tobacco P.l.c. and Imperial Brands Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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