Dividend investors looking for high-yield stocks have to carefully balance risk against reward. Reaching too far for yield can leave you owning a struggling business that might someday cut its dividend.
A good example of this today is British American Tobacco(NYSE: BTI). Here's why conservative income investors should pass on the cigarette maker's 8.1% yield and instead go with Realty Income's (NYSE: O) 6% yield.
British American Tobacco's worrying business trend
Roughly 80% of British American Tobacco's revenue comes from its combustibles division; cigarettes account for some 98% of the volume in that division. It is, without a doubt, a cigarette company.
Image source: Getty Images.
Its cigarette volume declined 6.8% in the first half of 2024 (the European company reports semiannually, so that's the most up-to-date volume data available as of this writing). That's the continuation of a long trend. Volume fell 5.3% in 2023, 5.1% in 2022, 0.1% in 2021 (a year that benefited from pandemic uncertainty), 4.6% in 2020, and 4.7% in 2019.
When the best year for volume in the past five is a 0.1% decline, you know there's a fundamental business problem. This is the main reason the dividend yield is so high.
British American, like its cigarette competitors, has managed to offset the declines with price increases, allowing it to support its lofty dividend. But at some point, it seems likely that rising prices will simply make the volume declines worse. Dividend investors probably won't want to own the company when that tipping point is reached because the dividend could quickly become unsustainable.
Realty Income's business is boring but reliable
Essentially, buying the cigarette maker is a high-risk bet that the company can somehow manage to keep supporting its dividend despite the long-term decline of its most important business. Buying Realty Income, on the other hand, is a bet that the company can continue to expand, and maintain or increase its dividend, just as it has for three decades.
To be fair, Realty Income, a net lease real estate investment trust (REIT), is a very different business than British American Tobacco, but it too offers up a very attractive yield.
As a REIT, Realty Income's business model is designed to pass income on to investors. So that's part of the reason for the high yield.
That said, net leases, which require tenants to pay most property-level operating costs, are something of a spread investment. Interest rate volatility has made the near-term business environment a little more difficult, which further explains the high yield.
The basic business, however, remains strong, with Realty Income estimating that there's an over $12 trillion addressable market for it to exploit. Although it is the largest net lease REIT, with a market cap of $46 billion, it looks like there's plenty of room for growth ahead.
The REIT's history is very good. For example, it has increased its dividend annually for three decades, something that wouldn't be possible if its business model were flawed or in decline.
And it has a strong record of success, noting that even during the depths of the Great Recession, occupancy didn't fall below 96%. Moreover, the company continues to invest for the future, with roughly $2.1 billion in property additions through the first nine months of 2024.
To be fair, Realty Income is a slow and steady tortoise at this point. Indeed, it is so large that it needs a large volume of acquisitions to move the needle on the top and bottom lines.
But it is still growing, and its core business remains fundamentally sound. That makes its high yield much more attractive than the even-higher yield offered by British American Tobacco, a company whose core seems like it is crumbling.
Be careful what you reach for
The S&P 500 index(SNPINDEX: ^GSPC) is yielding a very tiny 1.2% or thereabouts today. So both Realty Income and British American Tobacco are high-yield stocks. But they represent vastly different levels of risk, based on the businesses supporting their lofty yields.
There's no indication that British American Tobacco's dividend is facing an imminent risk of being cut, but the longer-term risk the dividend faces from the steady declines in its tobacco operations shouldn't be ignored. A slow and growing industry leader like Realty Income, despite a slightly lower yield, will probably be a better option for most dividend investors.
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Reuben Gregg Brewer has positions in Realty Income. The Motley Fool has positions in and recommends Realty Income. The Motley Fool recommends British American Tobacco P.l.c. and recommends the following options: long January 2026 $40 calls on British American Tobacco and short January 2026 $40 puts on British American Tobacco. The Motley Fool has a disclosure policy.
