Don’t Get Caught In This Tricky Dividend Trap!
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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.
Let’s start by looking at how companies actually behave.
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?
Know The Warning Signs
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.
When “Low” Yields Pay You MORE MONEY
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.
High Yields Aren’t Always The Best Route To High Returns
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.
How High Is Too High?
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.
Category: Dividend Bust
