Will high yield stocks will cost you in the long run?

Dividend investing has gained popularity as a great way to develop passive income while protecting your initial investment.  However one of the common mistakes that dividend investors make when they start out is that they simply focus on the highest yielding dividend stocks.  The thought process is fairly simple: Company A is yielding 3% and company B is yielding 9% so doesn’t that mean three times the returns? All things being equal the answer is yes however all things are almost never equal. Dividend investors need to learn to balance the risk and rewards of chasing high yield dividend stocks.

I’m a firm believer in dividend investing. I think that it is a great strategy that will provide safe, stable and sustainable growth for the long run provided investors don’t simply chase high yield dividend stocks.  By only focusing on dividend income most investors are forgetting to protect their initial capital investment and they end up exposing their portfolio to too much risk.

Although it is true that high yield dividend stocks have the potential to show great returns in the short term, most investors will notice that over time most of the dividend income will have been eroded by stock depreciation.  I can’t think of one stable dividend stock that has sustained a double digit dividend for any extended period of time.

The potential for higher returns motivates most investors. Even I can be tempted when I see a juicy double digit dividend.  But any dividend greater then 10% automatically raises questions for me.  “How safe is the dividend?” should be the first thing running through your head when you see a high yielding stock.  The easiest way to determine this is look at the historic payout ratio for the stock.  Unlike the current yield of the stock this information takes a little more time and effort to track down.  If it is a well know name you may be able to find the payout ratio history at dividend.com. However I suggest starting with google finance and the company’s website to review the previous annual reports.

Let’s take the classic example of Yellow Media. Long though of a dividend darling of the TSX Yellow Media, the company that “owns and operates Canada’s properties and publications, including Yellow Pages directories, Canpages directories, YellowPages.ca” currently yield a juicy 17.2% dividend.  Wow 17% that means in less then 6 years you would have fully recovered your initial investment.  That is if they can sustain a dividend of 17 %… which they obviously can’t.  If you take a closer look at the stock the current payout ratio is almost 150% and the stock price has plunged almost 45% from its 52 week high.  All these signs point to a company in serious trouble which makes sense since after all when was the last time you used the yellow pages.

However, high yield dividend stocks should not be completely ignored.  Markets often over and undervalue stocks.  The goal of a good dividend investor should be to identify solid companies that currently out of favor and pounce on them. These high yield dividend stocks can represent a healthy part of a diversified portfolio.  But before buying any of these stock you should always ask your : “Does the market know something I don’t?”, “Is this dividend sustainable in the long term?”, “Is the stock price stable or wildly volatile?”

I’d love to hear more from my readers – How do you weigh the risks and rewards associated with high yield dividend stocks? Please feel free to comment below.

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    One Response to “Will high yield stocks will cost you in the long run?”

    1. Robert Barron says:

      Dear Lian MacDonald,

      RE: Investing in high yielding dividend stocks.

      I agree that Investing in such stocks is dangerous, because the high yield is due to a drop in price, and the drop in price indicates a problem in the company, however there are exceptions.

      I look for high yielders (yielding between 8% & 11%) then research as follows.

      1. They must have LOW DEBT because high debt is usually the problem.
      2. Their dividends (over past years) must be consistantly rising or static. (The drop in price bringing about the high yield)
      3. Their pay out ratio must average less than 100% (best less than 70%)
      4. Their ROE history to be double digit with low PE and PB.

      The question to ask is why the share price dropped in the first place. If due to sector, seasonal, or macro reasons then perhaps ok – - otherwise danger. Usually searching the web will give the answer.

      I calculate the intrinsic value by dividing the historical AVERAGE yield into the AVARAGE dividend – averaged over a number of years. If the resulting price is far greater than the current price (and the above 5 points are acceptable) then the shares are worth buying.

      The reward should be a good dividend while waiting for the price to rise. When the price does rise the yeild will automatically fall thus allowing swithing into another higher yielding stock, but no higher than 11% because higher yields are very dangerous – at the best meaning a dividend cut is coming.

      Best wishes
      Robert Barron.

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