Buying stocks with high dividend yields is an excellent way to invest. But it's not fool-proof.
In fact, if you shop by yield and yield alone, you're playing a dangerous game. It's called picking up nickels in front of a steamroller.
Admittedly, it may work for a while, but eventually I can assure you the steamroller will prevail.
That's why in today's low-growth environment, it's critical to know which dividend stocks NOT to buy.
Avoid the real duds and the dividends alone will be enough to bail you out of minor mistakes. Find yourself on the wrong side of the fence and your high-yield investment could end up being pretty costly.
Success comes from understanding the difference between the two. Here are three ways to separate the winners from the losers.
Avoid Stocks that are "On the Clock"
First, at all costs, investors need to avoid dividend stocks where the source of income will dry up in a few years, and the dividend payout doesn't add up to the amount you're paying for the stock.
You wouldn't think there would be any of those, but there are! Investors fall for them because of their high yields.
Here are a few examples where one day the well will suddenly go dry leaving investors with empty cups.
Great Northern Iron Ore Properties (NYSE: GNI): GNI yields a monster 17% and has a P/E of 4 times. In business since 1906, it looks very attractive-on the outside. However, on the inside its main asset is a lease on iron ore deposit-bearing land in the Mesabi Range which runs out in 2015. With three years left on the lease, investors can only earn 51% (3×17) of their money back. I just want to know where the other 49% is? There are some residual assets, but not enough.
Whiting USA Trust (NYSE: WHX): Another high-yielder, WHX pays out no less than 27%. The company has the right to a specified amount of oil produced from particular wells, which is due to run out in August 2015. Here the math will pay you back 81% (3X27), so it's possible you could make some money. However, it all depends what oil prices do. Shares are down 50% in the last month, which suggests that investors have finally done their arithmetic.
BP Prudhoe Bay Royalty Trust (NYSE:BPT): BPT yields 8%, stands on a P/E of 12.2 times, which looks perfectly normal. Set up in 1989, this trust has the right to a royalty on production from BP's Prudhoe Bay oil field. However, output from this field is expected to begin declining in 2018, and to cease altogether in 2027. Admittedly, this one's trickier, you have to make some assumptions. However one analyst, Shane Blackmon, has assumed an oil price of $90 per barrel and concluded that the total value of dividends payable by BPT before it runs dry will be $83. Since BPT's current price is $115, it's another one to avoid, though less obvious!
Many royalty trusts, used in the energy business, have a finite lifespan, or relate to oil wells etc. that will run dry – they are in other words an annuity not a real evergreen business.
It's tough to figure out whether that's true for most companies – but worth doing some research to find out!
Avoid Stocks with the Risk of a Dividend Cut
Investors should also avoid buying stocks where the earnings path is far below the annual dividend rate.
No matter how good the cash flow is in these companies, the dividends will eventually be cut back. When that happens the share price will tumble.
Here's an example of the second type of loser, where the earnings are far below the dividend rate.
Frontier Communications (NYSE: FTR): With Frontier, the warning signs are everywhere you look. The company has a trailing four quarter earnings per share of $0.10. Consensus forecasts for 2012 and 2013 are $0.20 and $0.21 respectively. Yet the dividend is $0.40. You don't need to be good at math to question that one.
In fact, Frontier seems to be spiraling out of existence. Three years ago the dividend was $1 per share and the stock price was double its current level. The company did a major merger with Verizon's rural landline operations in 2010, and either seems to have lost its strategic focus on rural subscribers or the focus never made sense in the first place. I'm not sufficiently an expert in the telecom sector to tell you which. Either way, in spite of a 10.8% dividend yield, FTR is a value destroyer.
Avoid Stocks with a Temporary Business Model
The last is less obvious and more difficult to spot. It's important for income investors to avoid stocks where the business model depends on temporary circumstances since the earnings could disappear quickly if circumstances change.
These companies invest in government guaranteed home mortgages, then fund them through repurchase agreements, earning the spread between short-term and medium-term interest rates.
If you can leverage this up to 10 times, as AGNC does, you end up with a very nice business in current markets. This allows AGNC to pay dividends of $5 per share and yield 14%.
However if these companies get their hedging wrong, or interest rates rise, they are dead meat since the value of their assets will decline while the cost of their funding will rise above their yield.
This is a picking up nickels in front of a steamroller business if there ever was one. It's just not suitable for investors with a time horizon longer than a few months.
As you can see, there are several ways you can actually lose money on your high income investment.
But if you can avoid them, what's left will give you a pretty good return!
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