If something looks too good to be true… you can bet that it is.
And nowhere is this truer than in the world of income investing. As investors, we’re drawn to high yields like moths to a flame. But incredibly appealing high dividends are generally only made possible by one of the following scenarios:
- The stock or fund is highly leveraged… and thus, at risk to any unexpected shifts in Fed policy. Closed-end funds and mortgage REITs can fall into this trap.
- The stock is paying out a “return of capital” in addition to the regular dividend, or simply returning your original investment back to you. This is common with certain oil and gas trusts.
- The market is pricing in a steep dividend cut and the current high yield you see is about to go up in smoke. A typical red flag for companies in distress.
All of these scenarios can be devastating when you don’t see them coming but the third is by far the worst.
Think about it…
When you do speculative trading, you go into it knowing that you could take losses. It’s part of the game. But when you’re investing for income, that’s generally money you can’t afford to lose. If you’re retired, you might need it to meet your basic living expenses.
So, what can we do?
Let’s consider two hypothetical stocks each priced at $100… one that sports a dividend yield of 7% and one that sports a still pretty respectable yield of 3%. This amounts to cash dividends of $7 per year and $3 per year, respectively.
Let’s now assume the high yielder keeps its dividend constant, while the low-yielder is growing its dividend at 20% per year. Five years later, that 3% payer will be paying out $7.46 per year in dividends, whereas the 7% payer will still be paying $7.
On your original cost basis, the “low yielding “stock sports a 7.5% dividend yield after five years. That’s not too shabby. It just requires a little patience.
Now, I should throw out one big warning here: Nothing in the world of investments is permanent. And more importantly, this is not an endorsement of a blind buy-and-hold strategy.
Today, a stock can raise its dividend at a healthy clip and then fall into financial ruin tomorrow. And in a severe bear market, pretty much all stocks get clobbered together. But if your goal is building a durable income stream, you shouldn’t overlook dividend growth.