High-Yield Stocks: A Double-Edged Sword for Income Investors
When it comes to investing in dividend stocks, one thing is certain: a high yield can be incredibly enticing. British American Tobacco (NYSE: BTI) is a prime example, boasting an impressive 8.6% yield that far surpasses the S&P 500 index’s 1.2% and the average consumer-staples stock’s 2.5%. But before investors get too excited, it’s essential to examine the underlying reasons behind this generous payout.
The 4% Rule: A Guiding Principle for Income Investors
One popular rule of thumb for income investors is to withdraw 4% of their portfolio’s value annually, without worrying about outliving their savings in retirement. While this figure is debated among experts, the core idea is that selling assets to fund living expenses can be avoided by relying on dividend income instead. This approach allows investors to preserve their principal and enjoy a steady stream of income.
The Allure of High-Yield Stocks
For investors seeking to augment their Social Security checks, a 4% dividend yield might not be sufficient, especially if their portfolio is relatively small. That’s why ultra-high-yield stocks like British American Tobacco, with its 8.6% yield, can be so attractive. By providing twice the income of the 4% rule, these stocks offer a more substantial income stream while protecting the investor’s principal.
But Be Cautious: High Yields Often Come with Risks
Most stocks with ultra-high yields have underlying issues that justify their elevated payouts. In the case of Enterprise Products Partners, a midstream master limited partnership with a 7.2% yield, slow expected growth is the primary concern. However, for companies like British American Tobacco, the situation is more complex.
The Struggles of British American Tobacco
British American Tobacco’s core business – selling cigarettes – is facing significant challenges. Cigarette volumes have been declining steadily, with a 6.8% drop in the first half of 2024, 5.3% in 2023, and 5.1% in 2022. To offset these declines, the company has been raising prices, but this strategy can only work for so long. If a consumer-staples giant like Coca-Cola were experiencing similar volume declines, investors would likely be alarmed.
The Sustainability of British American Tobacco’s Dividend
The question on every income investor’s mind is whether British American Tobacco’s lofty yield is sustainable. If the dividend remains intact, it could provide a comfortable income stream for years to come. However, if the company is forced to cut its dividend due to declining cigarette sales, investors could find themselves shortchanged in retirement.
A Risky Bet for Conservative Income Investors
Given the ongoing struggles in British American Tobacco’s core business, its high yield appears to be a risky proposition for conservative income investors. The company’s decision to change its accounting practices for U.S. operations, effectively acknowledging that they may become worthless within 30 years, raises further concerns about the long-term sustainability of its dividend. For those seeking stable income streams, British American Tobacco might not be the best choice.
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