If there's one thing that a dividend investor can't resist, it is a large yield. That's probably why British American Tobacco(NYSE: BTI) has caught your eye. At 8.6%, the stock's yield is way higher than the 1.2% you could collect from the S&P 500 index(SNPINDEX: ^GSPC) or even the 2.5% of average consumer-staples stock, using Consumer Staples Select Sector SPDR(NYSEMKT: XLP) as an industry proxy. But before you think that the stock's high yield will set you up for life, you need to consider a few facts.
British American Tobacco: Double the 4% rule of thumb
There's a rule of thumb that investors can withdraw 4% of the value of their portfolios each year and, for the most part, not have to worry about outliving their savings in retirement. While the actual 4% figure has been argued over, some suggest the number is lower and others that it is higher. The point here is that 4% of a portfolio isn't a huge amount of money. And it is actually based on the notion that you will sell assets to fund the 4% withdrawal of cash that you'll use to pay for living expenses.
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One of the reasons why income investors like dividend stocks is that the dividend income they generate allows them to avoid having to sell anything. They simply collect the dividend, and the principle remains untouched (and, presumably, it continues to throw off a stream of income in the form of additional dividends). This is where bigger dividend yields start to come into play.
If you own a stock with a 4% dividend yield, you are basically in line with the 4% rule. And yet, that's not a huge number. Unless your portfolio is fairly large, 4% may not provide you with that much income to augment your Social Security checks. But at over 8%, British American Tobacco can give you twice the 4% rule's proposed income stream. And, since it is dividend income, you get to protect your principal, too. No wonder so many investors are drawn to ultra-high-yield stocks.
There are big risks to consider with British American Tobacco
That said, most stocks don't have ultra-high yields unless there is a good reason. For some, such as 7.2%-yielding midstream master limited partnership (MLP)Enterprise Products Partners, the reason is slow expected growth. For other companies, however, the problem is that their businesses are under immense strain. That's the situation at British American Tobacco.
What's that strain? The company's most important business is selling cigarettes. But cigarette volumes have been in a slow decline for years. In the first half of 2024, cigarette volume fell 6.8%. In 2023, volume was down 5.3%. In 2022 the drop was 5.1%. This is clearly an ongoing issue.
Like other tobacco companies, British American Tobacco has been raising prices to offset the volume declines. That's working for now, but it is covering up what is a fundamentally weak business. If Coca-Cola, another consumer-staples company, was experiencing steady volume declines like this, investors would likely be running for the hills. The only thing keeping investors around at British American Tobacco is that huge yield.
If that huge yield is sustainable, it could set an income investor up for life. If it isn't sustainable, and there's a dividend cut, this high-yield stock could end up leaving dividend investors short of the income they thought they would have in retirement. Given the ongoing volume declines in the company's most important business, British American Tobacco's lofty yield looks like a fairly risky bet for most investors.
British American Tobacco lays out the problem
The interesting thing about British American Tobacco's backstory is that it isn't trying to hide the magnitude of the problem it faces. Quite the opposite. In 2023, it changed the way it accounts for its U.S. operations, effectively admitting that they will likely be worthless in as little as 30 years. That's a long time in some ways, but a person retiring today can live in retirement for decades. If British American Tobacco's cigarette woes continue, it is a very real possibility that the dividend won't be sustainable at its current level. This is probably not a great stock pick for conservative income investors.
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool recommends British American Tobacco P.l.c. and Enterprise Products Partners 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.
