Be Careful With High-Yielding Stocks

Have you ever looked at the dividend yield of a company and noticed that they seem to be paying a lot more than others of a similar class of stocks? It probably looks pretty attractive, right? After all, who wouldn’t take a 10 % dividend yield over, say, a 4% yield? But be careful. Double-digit yields are often an indication that the market doesn’t believe the current distribution is sustainable. 

Anytime you have a situation where you’re being rewarded more than what the market currently offers on average, you need to be suspicious. Remember that yields go up as investors perceive more risk, so they need to be compensated for that risk in the form of higher current return. So in some instances, a high dividend may be a signal that all is not well with that particular company. 

For example, let’s say a stock is trading at $100 and it pays an annual dividend of $5. Its yield is 5%. But then something happens to that company, causing its stock to go down by 50%, and it’s now trading at $50. If it’s still paying that $5 annual dividend, that means the yield on that company’s stock is now 10%. It’s a high yield, but the company is in trouble. If you just walked into the room and saw that 10%, it might look great. But you have to look deeper.

This is where the details matter. Ask some questions. 

What business is the company in, and what is the asset class? If you’re investing in corporate junk debt, you’ll demand a higher current return than investors in investment-grade corporate debt.

And where has the stock traded historically? If the yield has never been in this range before, something could be seriously wrong. Or maybe the entire business type or asset class has been repriced in the market.

In these instances, a company has a couple of resolutions. They can cut the dividend, although oftentimes that causes their shares to go even lower. Or they could try to just keep the dividend payment flowing even though the profits aren’t there to support it, maybe by selling off certain assets or working on ways to reduce costs. But companies that do that often reduce their ability to make future profits as well. Either way they go, they’re running some kind of risk.

The takeaway here is that you should always look behind the curtain to find out what’s really going on. You’ve likely heard the expression that if something sounds too good to be true it probably is. That’s a really good thing to keep in mind. If a company is paying a 13% dividend when everyone else is paying 3% or 4%, something’s wrong. “Quality” very rarely trades at a double-digit yield. 

Read the prospectus, check the financial statements, do your homework, and find out what’s generating those high dividends. If it isn’t coming from profits, you could be taking on more risk than you bargained for.

Have questions? Give us a call. We’re here to help!

Information presented should not be considered specific tax, legal, or investment advice. You should always seek counsel of the appropriate advisor prior to making any investment decision. All investments are subject to risk including the loss of principal. This material was gathered from sources believed to be reliable, however, its accuracy cannot be guaranteed.

No client or prospective client should assume that the presentation (or any component thereof) serves as the receipt of, or a substitute for, personalized advice from LCG or from any other investment professional.

It is important to keep in mind that investments in fixed income products, debt of a corporation, are subject to liquidity (or market) risk, interest rate risk (bonds ordinarily decline in price when interest rates rise and rise in price when interest rates fall), financial (or credit) risk, inflation (or purchasing power) risk and special tax liabilities. Interest may be subject to the alternative minimum tax. Treasury securities are backed by full faith and credit of the U. S. Government but are subject to inflation risk.

Rick Plum is a registered representative of, and offers securities through, Lucia Securities, LLC, a registered broker/dealer, member FINRA/SIPC. Advisory services offered through Lucia Capital Group, a registered investment advisor, and an affiliate of Lucia Securities, LLC. Registration with the SEC does not imply a certain level of skill or training.

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