Watch Out for the Dividend Yield Trap
A perfect storm for losses is setting up…
The never-ending euro crisis keeps dragging stock prices lower and pushing yields higher. As I write, almost 15% of the stocks in the S&P 500 sport yields that are double that of 10-Year U.S. Treasuries. Even more staggering, nine stocks yield triple the amount of U.S. Treasuries.
As the chart below reveals, such conditions are rare. Going back to about 1955, 10-Year Treasuries have almost always yielded more than stocks.
At the same time that yields are spiking, investors are exhibiting all the traits of what the popular financial blogger, The Reformed Broker, calls “income worship” – feverishly seeking safety and a bit higher yield than bonds in dividend-paying stocks.
Here’s why this could end badly…
A Double-Whammy of Losses
Blindly chasing after yields is akin to the value trap. That’s when investors ignore underlying company fundamentals and are drawn into a stock because of its cheapness. Only with the dividend yield trap, investors ignore the fundamentals and are drawn into a stock because of its high yield.
Both traps are dangerous. But the dividend yield trap is more so.
You see, with a traditional value trap, a cheap stock with poor fundamentals tends to remain cheap indefinitely. Investors don’t end up sacrificing much capital in a value trap, as they can often exit with a small or no capital loss. Their real loss is the opportunity cost of not investing in a better alternative.
When it comes to the dividend yield trap, however, a high-yielding stock with poor fundamentals is often forced to cut its dividend. And when that happens, watch out! Investors get hit with a double whammy.
Not only do they lose the income they coveted, they also get handed a sizeable capital loss, as stock prices often plummet after dividend cuts.
Tread Carefully With These Five Stocks
I understand that resisting the temptation of a high-yielding stock can be difficult, if not near impossible. After all, who wouldn’t like to pocket the income offered by the five highest-yielding stocks in the S&P 500 shown below?
But if we look beyond the yield, these five companies don’t appear near as appealing. Take the three telecoms – Frontier Communications (NYSE: FTR), CenturyLink (NYSE: CTL) and Windstream (Nasdaq: WIN). They sport triple-digit dividend-payout ratios of 500%, 158% and 192%, respectively.
That means they’re paying out more in dividends than what they’re making in profits each year. How’s that possible? Well, they’re either using up cash reserves or borrowing money to do it. Or both. And that’s just not sustainable.
If the underlying businesses don’t generate more profits, something’s going to give. And it’s most likely going to be the dividend.
Bottom line: If you find yourself in search of income as we head into 2012, don’t be tempted by yield alone. Strong business fundamentals should always take priority over any income you might receive.
Instead, consider Canadian bank stocks, particularly Royal Bank of Canada (NYSE: RY). Although they offer slightly lower yields than the stocks listed above – about 5%, on average – they’re considerably safer. And they’re likely to keep raising their dividends because of solid business fundamentals, instead of cutting them.
Ahead of the tape,