Why Chasing Stock Yield Is a Bad Idea

Introduction

If you’ve ever done investment research on individual companies, you may have noticed that the dividend yield of some companies seems to be a lot higher than others of a similar class of stocks. And sometimes those higher yields look pretty attractive, don’t they? After all, isn’t owning a stock with a 10% dividend yield much better than owning one with, say, a 4% yield?  

Well, maybe not – and this is where you really have to 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. As investors perceive more risk, the yields tend to go up so that the investors can be compensated for that risk in the form of a higher current rate of return. So in some instances, a high dividend may be a signal that all is not well with that particular company.  

Let’s Look at an Example

Here’s an example of what we mean. Let’s say a stock is trading at $100 and it pays an annual dividend of $5. That means its yield is 5%. But then let’s say that something happens to that company, and its stock goes down in value by 50%; so 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, in this instance, the company may be in trouble. This is something you wouldn’t know at first glance. If you just walked into the room and saw that 10% dividend yield, it might look great. This is why you have to look deeper and this is where the details matter. When this happens, you need to ask some questions.

What business is the company in, and what is the asset class?

If the yield is high because the stock recently dropped dramatically in value, perhaps the company is part of an outdated or declining industry and stands little chance of recovering.  Remember, having a higher yield doesn’t help much if the value of that stock is going down with little chance at recovery. 

Where has the stock traded historically?

If the yield has never been in this range before, there could be something seriously wrong. Or maybe the entire business type or asset class has been repriced in the market. Any number of things could be going on. 

When things like this happen, a company has a couple of ways to deal with it. They can cut the dividend, although in many instances 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 or by taking on more debt. But going this route often reduces a company’s ability to make future profits as well. Either way they go, they’re running some kind of risk. 

The Bottom Line

You should always look behind the curtain to find out what’s really going on. You’ve heard the expression that if something sounds too good to be true it probably is, and that’s one piece of advice that’s a good idea to keep in mind. If a company is paying a 12% dividend when everyone else in their world is paying 3% or 4%, something’s wrong. “Quality” very rarely trades at a double-digit yield.  

Instead of being drawn in by the lure of a high-dividend stock yield, you may want to consider those companies that are GROWING their dividend at a healthy rate.  Some may only yield 3 or 4 percent, but if that dividend is growing by, say, 10 percent a year due to fundamentals, you might be looking at a much better investment.  Just remember that none of these things are guaranteed. 

Either way, be sure to check the financial statements, do your homework, and find out what’s generating those high dividends. If they’re not coming from company profits, you could be taking on more risk than you bargained for. 

And by the way, this advice doesn’t just apply to stocks. In next week’s edition of Lucia Capital Group Weekly, we will discuss why the idea of “chasing yield” can also hurt you on the bond side of the ledger. Stay tuned for more!