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:
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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.