Dividend Stocks To Avoid by Ben Strubel, Strubel Investment Management

Dividend investing can be a great stock selection strategy. Numerous studies show that stocks with above-average dividends outperform the market when measured over long periods of time. The outperformance generated by dividend stocks, however, is usually found to be lower than that of other value-based strategies, such as buying low price-to-book or low price-to-earnings stocks. Nevertheless, dividend investing does some notable advantages over other value strategies.

Diversified portfolios of dividend stocks tend to be less volatile than other value investing strategies and the stock market as a whole. Also, dividend investing is one of the friendlier strategies for the novice investor. Finally, the performance of dividend investing strategies can be improved by looking at more factors than just a stock’s dividend yield.

While dividend investing is something that is relatively straightforward it doesn’t mean it is easy. There are some types of companies that the amateur dividend investor might want to stay away from. Retailers, non-diversified pharmaceuticals, and financial companies are the three that come to mind immediately.

Retailers

Retailing is a tough, competitive business. There is very little many retailers can do to set themselves apart. (Quick! What’s the difference between Bon-Ton Stores Inc (NASDAQ:BONT), Kohl’s Corporation (NYSE:KSS), J C Penney Company Inc (NYSE:JCP), and Boscovs?) Although retailers that sell their own branded merchandise, such as Buckle Inc (NYSE:BKE), American Eagle Outfitters (NYSE:AEO), Abercrombie & Fitch Co. (NYSE:ANF), and Gap Inc (NYSE:GPS) to name a few, may be able to differentiate themselves, they face the risk of becoming out of style. Retailers like RadioShack Corporation (NYSE:RSH) and Blockbuster are experiencing that fate as the things they sell become history.

The biggest problem with retailers is that the business model is very leveraged. In layman’s terms, this means that when things are going well and sales are rising then profits improve at a greater rate. On the other hand, when things go bad, profits drop faster than sales. The reason has to do with how retail businesses operate. For most retailers, many of the costs are fixed. They have fixed lease payments and store costs, they need to pay employees to be at the store whether there are a lot of customers or a few, corporate overhead costs are largely fixed, and inventory costs are fixed as well. (They need products on the shelves.) When sales turn south, they can’t cut costs to match. Conversely, when sales increase, their costs remain much the same so most of the extra sales flow through as profit.

It’s this leverage that makes investing in retailers a job for the professionals, and even then things don’t always work out. For example, J C Penney, a department store that has been around since 1902, has fallen on hard times. In 2012, the company cut its dividend. Now there is a real risk of bankruptcy for the venerable brand.

Or take the example of UK grocery behemoth Tesco. The company is the largest grocer in the UK and operates in 11 other countries.  It appeared in its current format as a grocery store in 1929. (The actual founding was in 1919 when the company was just a group of market stalls.) In 2014, the company announced a cut in its dividend amid slumping sales.

In both of the above cases, a smart, prominent investor had made the mistake of buying part of the company. Successful hedge fund manager Bill Ackman bought into J C Penney Company Inc (NYSE:JCP), and Warren Buffett was an owner of Tesco PLC (LON:TSCO).

If it’s easy for some of the best investors to make mistakes with retail companies, then it’s probably a good idea for amateur investors to stay away as well.

Non-Diversified Pharmaceutical Companies

Pharmaceutical companies are an area that amateurs should generally avoid. Unlike retailers, pharmaceutical companies have excellent business models. Patent protections give the companies access to lucrative revenue streams without major competition for long periods of time. Unfortunately, judging the success of new drugs and medical treatments before they hit the market is something that requires a specialist’s knowledge.

Large, diversified pharmaceutical companies have a place in investor portfolio. I’d recommend sticking to companies that derive 10% or less of their sales from any one drug. Leave the companies that are dependent on the success of a few drugs or development stage start-ups to the speculators and the pros.

Financials

Financial firms, especially the larger ones, are notoriously hard to analyze. For instance, investors considering buying Sherwin-Williams Co (NYSE:SHW) stock wouldn’t have a lot to research even though the company is one of the largest paint and coatings companies in the world. (We owned it back in 2009, but no longer own it.) All they would have to do is go to their local home improvement store and ask how sales are, check out how the real estate market was doing, and read through the company’s annual report (which was only 86 pages for 2013).

Conversely, how can we figure out what’s going with Bank of America Corp (NYSE:BAC)? What does the company’s loan portfolio look like? What about its asset management business? Its insurance business? What about retail banking? Where are interest rates heading? What kind of legal liabilities does the company face? You’ll probably find some but not all of those answers in the company’s voluminous annual report (which was 264 pages for 2013).

The business of BofA, and most financial firms, is infinitely more complicated than Sherwin Williams. Investors should stick to relatively simple and easy-to-understand businesses.

No Company Profiled This Month.

Dividend Stocks, Sectors To Avoid