Annaly Capital Management (NYSE: NLY) was one of the first real estate investment trusts (REITs) I ever purchased. The sole reason I bought shares was its alluring dividend yield. It was in the high single digits at the time. I remember thinking that the stock price doesn’t have to rise very much in order to earn an attractive return.

Unfortunately, the stock never gained any value in all my years of owning it. Instead, it steadily eroded as the mortgage REIT issued more shares at lower prices to fund its growth. Making matters worse, Annaly cut its dividend payment several times. My experience with the REIT taught me a valuable lesson: Don’t invest in a stock solely because of its dividend yield.

The higher the yield, the higher the risk

I’ve made a lot of investing mistakes over the years. One that has proven costly more times than I’d care to admit is investing in companies with high dividend yields without considering whether those payouts were sustainable. Instead of seeing a stock with a high yield as a red flag, I often saw it as an opportunity to earn an outsized income stream. While some of those investments have paid off, more often than not, the company with the high-yielding payout eventually cut its dividend payment.

In Annaly’s case, it cut its payout several times over the years:

These reductions have taught me to examine whether a company has the financial strength to maintain its dividend. I’ve learned that three factors help drive a company’s ability to sustain its dividend over the long term:

• Stable and growing earnings: It must operate in an industry where it can produce relatively steady earnings that can increase over time. In Annaly’s case, it has faced earnings headwinds from changes in interest rates. As its earnings declined, the REIT needed to cut its payout.

• An adequate cash-flow cushion: A company must have a reasonable dividend payout ratio (75% or less, depending on the industry). A lower payout ratio gives it a much-needed cushion to be able to weather an unexpected headwind and allows it to retain some cash to fund its growth. Annaly’s high dividend payout ratio forced it to issue new stock to fund its expansion, which weighed on its share price.

• A strong balance sheet: It needs to have a solid financial foundation. The best measures of this are an investment-grade credit rating and a conservative leverage ratio for its industry. While Annaly has traditionally operated with lower leverage, its other shortfalls have doomed its dividend.

Story continues

A data-driven mindset shift

I’ve adjusted my dividend focus over the years due to the costly lessons I’ve learned from my investment in Annaly and the data I’ve come across on dividends. That data shows a powerful correlation between dividend growth and outperformance:

Data source: Ned Davis Research and Hartford Funds. Note: Returns are from 1973-2023.

As that table showcases, dividend cutters like Annaly have historically produced a negative average annual total return. So, instead of getting me most of the way to the attractive return I sought, these companies put me further behind.

Similarly, companies with no change in their dividend policy (i.e., companies that don’t increase their dividends) deliver underwhelming returns (the 6.7% average annual return has underperformed the 7.7% return of an equal-weighed S&P 500 index). So, again, instead of the big yield making it easier to score an attractive return, these stocks have underperformed over the long term.

Dividend growers (and initiators), on the other hand, have delivered meaningful outperformance. They beat dividend non-payers, other dividend stocks, and the average stock in the S&P 500. That’s because these companies are growing their earnings per share to support a rising dividend. Earnings and dividend growth drive the stock price higher over the long run, contributing to higher total returns.

However, the data also shows that a stock’s dividend yield is important. Data from Wellington Management found that companies that paid a high yield (but not the highest) consistently delivered the highest returns. Those stocks tended to have a dividend payout ratio of around 40% compared to the 75% ratio of the highest-yielding stocks.

Focus on dividend growth, not yield

Investing in Annaly Capital Management taught me that buying a stock for its yield alone can prove costly in the long run. Companies with a very high yield typically can’t sustain their payouts forever, let alone grow them, which tends to cause their stock to underperform over the long term.

I’ve learned that a better approach is to focus on companies with higher-yielding dividends — but not the highest yields — that can consistently grow their payouts. They have historically produced the highest total returns over the long term by providing investors with a growing income stream and stock price.

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Matt DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Buying Annaly Capital Management Taught Me a Costly Lesson (That Will Pay Dividends in the Future) was originally published by The Motley Fool