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Hi, My name is Aaron and I‘m with Dividend Stocks Research, and today
were reviewing our recently published article…
Beware.
Those high yield dividend stocks you keep seeing could be nothing but
trouble.
Expensive trouble
There’s a reason why the S&P 500 pays an average dividend of 1.91%.
But you keep running into stocks that pay dividends of twice this
much. Or even three and four times this much.
Today, I’m going to tell you what you need to know to steer clear of
the costly high dividend trap.
Every company behaves differently, but most fall into one of two
buckets. They either try to create shareholder value by reinvesting
profits in the company and driving up the company’s revenues and
earnings, or they focus on distributing dividends.
No matter what kind of a stock you’re looking at, you can’t escape
the fundamental connection between risk and reward.
If you’re going to think about investing in high yield dividend
stocks, you need to proceed with caution. There is usually a good
reason why a company pays a high dividend, and this reason usually doesn’t have much to do with the
company’s desire to be generous to dividend investors.
So how can you find a high yield dividend stock that’s going to give you an edge? How can you steer
clear of the train wrecks that send so many of these stocks off the
rails?
Stay out of trouble by knowing the warning signs. One of the best
warning signs is when a company starts shoveling so much of its
profits into dividend payments that it starts making sacrifices in its own
operations.
It might not be able to pay enough to attract or keep the best people.
It may have to cut back on research, or hold off paying back a debt. The company might not have the money in the bank that’s needed to upgrade
a facility or make an acquisition.
What’s the easy way to see if this is happening?
Look at the dividend payout ratio. This shows the percentage of profits
rolled into the dividend payment.
You’ll see that the payout ratio is different from industry to industry.
But generally speaking, when a company starts plowing more than
half of its profits back into dividends, investors should take
notice.
There might not be enough money on hand to grow the business. The higher dividend payment could be a short-term tactic by management to
attract new investors.
The pattern of the payout ratio is also good to keep an eye on. A
sudden spike could mean trouble ahead. If a company that
traditionally follows a payout ratio of 40% moves into the 70% range,
there could be a problem.
So walk away. Take a safer path. And by settling for what seems like
less, chances are good you’ll actually come out ahead.
High yield dividend stocks can lure you in and then spit you out not
once, but twice.
How can this happen?
You get hurt if the dividend is cut. The reason you bought the stock has
gone away, or has fallen back to earth with a much more reasonable
yield.
And then there’s the price you paid for the stock. Even if the high yield
is still paid and the price of the stock goes down, you’ve got a problem.
Naturally, the price of a stock that pays a more reasonable and reliable dividend can go down as well. But over time, stocks with a history of
dividend growth and consistent distributions tend to hold up better in market downdrafts. The dividend yield can actually help support the
price.
There’s another way to go and that’s dividend growth. A great
example of this is IBM.
In the Spring of 2014, International Business Machines Corp. (IBM)
boosted its quarterly dividend by $.15. It went up to $1.10 a share.
The actual yield was anything but high... a modest 2.3%. But the
consistent growth, 19 years of an annual increase, and 11 consecutive
double-digit increases, is what rewards shareholders.
Since 2000, IBM has increased dividend payments by 800%. Over
the past five years, they have doubled.
IBM is a great reminder that the chase for a high yield isn’t always
the best way to capture high returns.
It’s usually better to focus on stocks that can deliver consistent dividend growth than just to focus on a high
dividend.
This means you’ve got to know the territory. Know when the numbers
start to send warning signals.
Exactly when do high yield stocks move into risky territory? What’s a
reasonable yield?
When you check out the yield of the Aristocrats, the most reliable
dividend paying stocks, you’re looking at yields in the 2-4% range. Notable exceptions: HCP Inc. (HCP) and AT&T (ATT) with yields above
5%.
Keep in mind that HCP is a REIT, a real estate investment trust, which by law can avoid paying income tax if 90% of its profits are paid out in dividends. It is also the only REIT
on the S&P 500 Dividend Aristocrats Index.
So when you run into yields higher than 4%, you’re looking at a double-
barreled risk. A 5% yield can evaporate quickly when the stock
price goes down. Simple arithmetic turns ugly when you subtract capital
losses from dividend income, and the higher the yield, the more likely
this is to happen.
What happens when a stock you bought because it paid a modest yield starts to pay a high yield?
The easy answer is take the money and run.
You’re in a good position to sell and take your profits. The desire not to leave any money on the table and
wait for another dividend to be paid is understandable, but it can also be
an easily avoidable risk.
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