The Motley Fool

1 Deadly Mistake Income Investors May Be Making

Some income investors have only one goal in mind, and that’s to maximize their portfolio’s dividend yield. It’s a simple strategy, but I believe some income investors are putting long-term returns in jeopardy in favour of a few short-term dividend payouts. Some income investors are tempted to buy stocks that yield 7-9% without taking a look at the long-term fundamentals of the business. This could result in dividend cuts and capital losses in the long run.

As the dividend yield increases above 7% for a falling stock, so does the risk. These stocks become artificially high-yield stocks, which means that the management team never intended the yield to get that high. An artificially high-yield stock is usually unstable since the struggling business may not be able to cover the payout with its free cash flow. If the business doesn’t pivot overnight, then dividend cuts of 50% or more could be in the books for the next 12 months.

How do you avoid such risks when investing in high-dividend-paying stocks?

It’s very dangerous to simply look for the highest-yielding stocks from a stock screener. Almost all of the results that show up are value traps that could leave you broke really fast.

Companies with 9% dividend yields are likely on their knees and could see capital losses which exceed the high yield that is currently being paid out. Because the company is falling so fast, it is very likely that a turnaround will not be possible without some re-investment into the company.

Since these companies are cash-strapped, it is often necessary to cut part of the dividend if they are barely able to cover the payout through their earnings. In some cases, the dividend may be cut entirely, so the company can use all of its cash to re-invest in the business to turn it around.

When investing in companies with yields north of 7%, make sure you study the financial statements closely. Have a look at the last few years of dividend payouts and determine if the company was able to cover these payouts from its cash flow.

If a company is not able to cover a payout using its cash flow for a given quarter, then the risk of a dividend cut becomes greater. If this has happened on more than one occasion over the past year, then a cut may be imminent and you should avoid the stock at all costs.

What would a Foolish income investor do?

If you seek high-yield stocks, have a look at the last decade of dividend payouts and see if the company cut the dividend during this period. If there’s no history of dividend cuts and there is an occasional dividend raise, then the stock has a safe yield that you can expect to be paid through thick and thin.

One such stock is RioCan Real Estate Investment Trust (TSX:REI.UN), which pays a bountiful 5.23% yield; it hasn’t cut its dividend in the last decade, even during the Financial Crisis. The dividend has been hiked an average of once every two years by about 3%. The company has a very healthy balance sheet to support dividend payouts even during the harshest of economic downturns, so the stock is a high-quality dividend payer that is likely to enjoy capital gains over the long term.

It makes more sense for a long-term income investor to buy stable, safe, growing, dividend-paying stocks, and not artificially high-yielding stocks. If you chase extremely high yields, you’re attempting to catch a falling knife, and that’s never a good investment strategy.

Stay smart. Stay hungry. Stay Foolish.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Joey Frenette has no position in any stocks mentioned.

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