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When Dividends Become Dangerous Attractions

Dividend paying shares are attractive for investors as these pay-outs can constitute a source of passive-income. Besides, studies have also shown that dividends constitute a major component of long-term stock market returns so there’s a strong case in favouring dividend shares over those that do not pay a dividend.

But, it is also dangerous to superficially accept the conclusion that a share’s superior just because it pays a dividend. In some cases, dividends can mask potential danger.

Case 1: The business deteriorates

CH Offshore (SGX: C13) owns vessels and ships that supports the oil & gas industry. For its last completed financial year (which ended on June 2012), it paid a dividend of 0.75 Singapore cents and 4 Singapore cents for the quarters ended Dec 2011 and June 2012 respectively. That would give them a very attractive historical dividend yield of 10.8% based on its current price of S$0.44 per share. To put the attractiveness of CH Offshore’s yield in context, the Straits Times Index (SGX: ^STI) had a dividend yield of only 2.96% as of 31 May 2013.

Since then, however, the company has cut its dividends as there were no payments made for the quarter ended Dec 2012. CH Offshore has repeatedly warned about the expiry of two long-term contracts for their vessels which can affect the company’s performance in the on-going financial year as any new contracts will likely bring in lower revenues.

So far, the three completed quarters for the current financial year have delivered revenues that are 8% lower than the corresponding period in the previous year, while earnings came in 4.4% lower. That’s hardly catastrophic, but that does not mean the danger of continuously falling revenues (and with it, declining earnings) in the near future is not possible. In situations like with CH Offshore, recent dividends and a strong dividend yield might lull investors into sleeping at the wheel when it comes to detecting danger.

Case 2: Taking on debt to boost dividends

Luzhou Bio-Chem (SGX: L46) is a producer of sweeteners made from corn. Last year, the company paid out a dividend of 0.5 Singapore cents to give its shares a dividend yield of 6.7% based on the current share price of S$0.075. That’s its first pay-out since 2007, so all must have been good for shareholders, right?

Turns out, the company’s bottom-line last year had shrunk by 71% to RMB 11.7m while operating cash flow followed suit with a decline of 76% to RMB 47.2m. To make things worse, Luzhou’s balance sheet had deteriorated from a net-debt position of RMB 473.8m to RMB 592.8m.

It seems almost as if the company had to pile-on more debt to ‘reward’ shareholders with some dividends. Simply put, reinstating dividends in the face of falling earnings, cash flow and a weaker balance sheet does not jive with the standards that responsible stewards of shareholder’s capital should be held up to.

Foolish Bottom Line

Before investing in any dividend-paying share, it pays to look beneath the hood for potential danger signs such as those mentioned above. Not every dividend paying share is a good investment just because it is paying a dividend.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.