Beware of Chasing High Dividend Yields

What’s the easiest way to find a stock with a 10% dividend yield?

Find a stock yielding 5% and watch its price get cut in half.

I say this mostly in jest, but this is precisely what happened to investors in RadioShack (NYSE:$RSH), the iconic electronics and gadgets chain still found in most American shopping malls.  At time of writing, RadioShack yields 9.8%, and this is after the company already slashed its dividend.

Given that it is paying out substantially more than it earns, RadioShack will almost certainly further reduce or eliminate its dividend in the coming quarters.  The company barely earns a profit, and it faces a war of attrition it can’t win against larger “big box” rivals like Best Buy (NYSE:$BBY) and Wal-Mart (NYSE:$WMT) and from internet retailers like Amazon (Nasdaq:$AMZN).

In a race with no winners, it will be interesting to watch what falls faster, RadioShack’s price or its dividend.

I’ll quit beating up on RadioShack.  In fact, I wouldn’t be surprised to see the company enjoy a nice rally in the months ahead.  No one can argue that RadioShack is not cheap; the stock trades for 0.67 time book value and a shocking 0.11 times sales.  Almost incredibly the stock currently sells for less than the value of its cash in the bank, $4.97 vs. $5.70.  (Before you value investors start licking your chops, keep in mind that RadioShack has substantial debts against that cash; as of year end, the company had $1.4 billion in debts vs. a little under a billion in cash and receivables.)

The stock could also benefit from a dead-cat bounce.  With the short interest in the stock currently more than seven times the average daily trading volume, it could benefit from a short-covering rally if nothing else.

But that is exactly how investors should view RadioShack—as a potential short-term trade and nothing more.  It should certainly not be considered a long-term income play, as that 9.8% yield can disappear overnight.

This brings me to the point of this article: an investor should never chase a high dividend yield.

Exceptionally high dividend yields generally mean one of two things:

1. The dividend is expected to be the only source of return, and investors should not anticipate much in the way of capital gains.
2. The dividend is at serious risk of getting cut and the market has already priced the stock accordingly.

The first category is not all bad, so long as investors understand this going into the trade.  Many popular investments such as mortgage REITS would fall under this category.  Annaly Capital (NYSE:$NLY) and Chimera Investment Corp (NY6SE:$CIM) both currently yield in excess of 13%.  The dividends are by no means stable, however, and the payout will almost certainly fall when the Fed eventually raises rates.

Tobacco companies have enjoyed phenomenal returns of late and have been the Sizemore Investment Letter’s best-performing investment theme over the past year (see “Tobacco Stocks Still Smokin’”), but they too should be considered zero-capital-gains investments over the longer term. Investors can profit quite handsomely from the reinvestment of dividends and from share buybacks, but this is a sector in long-term terminal decline.

It is the second category where investors tend to get themselves in trouble, both in the stock investing and bond investing.  Alas, your humble correspondent was one of the hapless souls who bought shares of Thornburg Mortgage in 2008 because it had a yield of over 10% and a “solid” portfolio of super-prime jumbo mortgages.  That 10% yield didn’t get me very far when the company filed for bankruptcy. How many other investors were seduced by the 20-30% yields offered on General Motors bonds around that same time?  Again, we know how that worked out.

Investors can avoid these traps by setting reasonable expectations.  If a yield seems too high to be true, it probably is.  Roll up your sleeves, take a look at the company’s financials, and make that judgment call with a sober mind.

Income seekers currently have their pick of the litter of safe, moderately high-yielding stocks with room for dividend growth and price appreciation.  As an asset class, master limited partnerships are attractively priced, and several—including Williams Partners (NYSE:$WPZ) and Kinder Morgan Energy Partners (NYSE:$KMP)—yield over 5%.

REITS are more expensive as an asset class, buy here too there are bargains to be found.  National Retail Properties (NYSE:$NNN) and Realty Income Corp (NYSE:$O) yield 5.7% and 4.5%, respectively, and consider both to be safe.

Investors willing to accept modest risk of a temporary dividend cut should consider Spain’s Telefonica (NYSE:$TEF).  Telefonica currently yields over 10%, and its share price has taken a beating along with the rest of the Spanish stock market.  I consider a dividend cut to be unlikely, though the Board may opt to conserve cash if the European capital markets seize up again.  Still, any cut in this case would be temporary, and I expect the dividend to be substantially higher 3-5 years from now.  Unlike, say, RadioShack, Telefonica has a healthy business with excellent long-term prospects, particularly in Latin America.  Use any weakness as a buying opportunity.

Disclosures: KMP, NNN, O and TEF are all holdings of Sizemore Capital’s Dividend Growth Portfolio.