These Dividends Are Outrageous

With short-term Treasuries close to zero and money-market rates not much higher, it's fitting that investors are looking elsewhere to generate some income. Unfortunately, in the scramble to find higher yields, many investors have gotten themselves into some pretty dangerous territory.

Too good to be true?
Closed-end funds have really become popular in the last year, and deservedly so. In 2009, the average closed-end fund returned 51.5% on a share price total return basis. Accordingly, cash-seeking investors have poured their money into the funds, hoping to grab a piece of the pie.

But first I'd like to explain why you should be seriously cautious about these funds, and second, I'm going to offer five much better opportunities for you to invest in.

To understand these funds, it is important to differentiate them from a regular mutual fund. Closed-end funds are similar to stocks in that they trade not based on their net asset value (NAV), but on the open market, at a premium or discount to the NAV, depending on how the market evaluates it.

According to a recent Wall Street Journal article, 11 funds tracked by Lipper were trading for at least 20% more than their portfolio's NAV. That means that investors willingly paid $1.20 or more for $1.00 worth of assets -- this doesn't exactly follow the Buffett principle of paying less for more.

So why the big markup?

Dividends, usually. Closed-end funds have insanely high yields and offer people a chance to generate substantial income while they wait for interest rates to inch their way up from the bottom. Gabelli Utility Trust (GUT), for example, is selling at a whopping 58% premium. By now you can probably guess why an investor would be willing to pay such an incredible premium-- the fund offers an extremely generous 9.3% yield.

Gabelli Utility Trust holds companies like Allegheny Energy (NYSE: AYE  ) and Great Plains Energy (NYSE: GXP  ) -- in my opinion, you'd be better off owning these companies separately. Both sport dividend yields of 2.8% or above and are trading below 12 times forward earnings. Why pay a premium for this fund when you can own the individual parts for less?

Less yield than you think
That 9.3% that you're probably gushing over right now is incredibly deceiving. Closed-end funds have what is called a "managed distribution policy," where they can return to the investor not only a regular dividend, but also long-term capital gains -- and even a portion of your original capital. This is done to provide investors with some semblance of a steady cash flow. Capital gains and original capital shouldn't be included in the yield calculation, but most times, they are. For instance, even though Gabelli's yield looks like 9.3%, the actual "income-only" yield is about 3.7% -- quite a surprise for investors who think they're getting a high traditional yield. (These numbers can be found on the Closed-End Fund Association's website.)

This would be bad enough, but it only gets worse. Closed-end funds can also cut their dividends at any time, without explanation or reason. For example, The Wall Street Journal cited the Dow 30 Enhanced Premium & Income Fund, which cut its dividend in half in 2009 -- with no explanation at all. Shares then proceeded to crumble from a 30% premium to a 3% discount, leaving investors with their share price cut by a third.

Any time a fund randomly chooses to cut its dividend, a run on the fund will typically ensue; not only is your cash flow suddenly depleted, but your shares have been slashed as well. When all is said and done, these funds end up being quite a risky and imprecise investment.

More bang for your buck
Now that I've explained why closed-end funds aren't the best investment vehicle for your hard-earned savings, I'll make good on my promise to offer a much better alternative.

Let's look at an investment that offers the three following attributes:

  1. A generous amount of reliable income
  2. A track record of continuity and the capacity to raise dividends over time
  3. The ability to deliver capital appreciation

Dividend-paying stocks with the characteristics above are far greater investments, because their yields are more transparent, and they can generate not only income, but also growth.

In light of this new information, here are five stocks that fit the criteria we set above:

Company

Current Dividend Yield

3-Year Dividend Growth Rate

3-Year Net Income Growth Rate*

AT&T (NYSE: T  )

6.5%

7.7%

10.7%

Bristol-Myers Squibb (NYSE: BMY  )

5.3%

4.4%

88.5%

Turkcell Iletisim Hizmetleri (NYSE: TKC  )

5%

18.7%

7.7%

Abbott Labs (NYSE: ABT  )

3.5%

10.4%

50.8%

Coca-Cola (NYSE: KO  )

3.3%

10%

10.6%

Data from Capital IQ and DividendInvestor.com.

These are the types of companies that Motley Fool Income Investor seeks out -- stocks that pay generous dividends, have raised those dividends over time, and have illustrated the power of increasing earnings year after year.

It's completely understandable that investors are in search of better yields -- but it's important to remember that if a dividend looks too good to be true, it probably is.

If you're interested in learning more about the five stocks that our analysts at Income Investor think you should buy right now, or if you'd like to see all of our past and present recommendations (which are beating the market by an average of six percentage points each), you can be a guest of the service, free for 30 days. Click here for more information.

Already a subscriber? Log in at the top of the page.

Jordan DiPietro owns no shares mentioned above. Coca-Cola is a Motley Fool Inside Value recommendation. Turkcell Iletisim Hizmetleri is a Motley Fool Global Gains pick. Coca-Cola and Turkcell Iletisim Hizmetleri are Income Investor selections. The Fool's disclosure policy knows that reinvesting dividends is a major key to financial success.


Read/Post Comments (19) | Recommend This Article (127)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 29, 2010, at 5:30 PM, sapereaude1 wrote:

    Generally speaking, I think it's a mistake to own any mutual fund. I believe that statistics bear this out.

  • Report this Comment On April 29, 2010, at 5:53 PM, notgilstratton wrote:

    If you want really big yields, take a good look at MLP's. It's all about yield, the capital gain is a bonus. Check out LINE, LGCY, STON, just for starters.

  • Report this Comment On April 29, 2010, at 5:55 PM, TMFBreakerRob wrote:

    Good article, Jordan. Its amazing how many people will invest in securities without understanding what it is that they are buying. In this case, I don't blame the fund, I blame the poor unknowing sap that stepped into an arrangement that was different than he or she "assumed".

    Too bad.

    At least in a fairly knowledgeable investment community, a person can solicit input from folks. Could be quite a savings if they ask in the right places...

  • Report this Comment On April 29, 2010, at 9:54 PM, jonesj123 wrote:

    Help me out. I own JCE which is Nuveen Core Equity. I understand they write options against their portfolio and it is a bit levereged. It was originally paying 12% when I bought it and has paid some nice dividends which I reinvested. It was selling at a discount. I have not looked today. I would appreciate some comments.

  • Report this Comment On April 29, 2010, at 10:53 PM, OklaBoston wrote:

    Why no mention of payout ratio anywhere in this article? While I can understand no wanting to buy a stock that pays no dividend at all, I can't understand buying into a company that pays out an excessive percentage of it's income.

    I'm open to suggestions on what constitutes an excessive payout ratio, though 25% is the 1st number that comes to my mind.

  • Report this Comment On April 30, 2010, at 1:02 AM, velcro1dog wrote:

    I disagree. You listed what the worst fund out of the whole group to make your point. It could easily go the other way also showing certain funds that out perform your stock picks. Every investment is risky to some degree. Knowing the risk of any stock or fund is a good investor. The problem is their is alot of people that do not understand anything about the stock market. Therefore a good mutual fund with a long track record may be their best and only option. They also do not subscribe to any newsletters and refuse or are not capable of learning about stocks.

  • Report this Comment On April 30, 2010, at 7:34 AM, plange01 wrote:

    great dividends look at nly and cim a spinoff..mo,vz,kft,ba,pm a few smaller but better growth...

  • Report this Comment On April 30, 2010, at 7:53 AM, neskolf wrote:

    OklaBoston:

    Good point on the payout ratio. It needs a mention when talking about sustainable dividend growth (or even continued payment!).

    As to what to consider an acceptable payout ratio, that's a variable. For example, I don't mind seeing a utility with a payout ratio between 80-90% because there's really not much room for growth (if any), so why not pay it out to the sharholders? Because of their structure, MLPs will have high payout ratios.

  • Report this Comment On April 30, 2010, at 9:23 AM, mikecart1 wrote:

    Another dividend article that leaves out King MO. Thumbs DOWN on this article.

  • Report this Comment On April 30, 2010, at 3:19 PM, bwac wrote:

    Closed End Funds often sell at a discount, and if held in an IRA, can provide income sufficient to cover required minimum distributions. They are easily investigated in CEF Connect, and appear to my unsophisticated eye to be suitable for retirement accounts.

  • Report this Comment On April 30, 2010, at 3:22 PM, OklaBoston wrote:

    neskolf:

    As a person primarily interested in capital gains I'm not going to be very big on utilities unless I'm anticipating a serious bear market.

    IMO, the worst thing about a high payout ratio is that it slows the growth of book value, the soundest foundation for capital gains.

    What would be a good payout ratio for a company hoping to grow it's book value by, say, 10-15% annually?

  • Report this Comment On May 01, 2010, at 1:30 PM, stephen706 wrote:

    How can you have an article on Dividend and not include WWE, paying 1.44$ per share for the past few years, and continuing... it is a cash cow but absolutely no respect.

  • Report this Comment On May 07, 2010, at 3:51 PM, highnhard wrote:

    check out ERF and PVX

  • Report this Comment On May 07, 2010, at 3:52 PM, Gorbud wrote:

    Is it me ? Verizon is up and down within parameters but its 6.2% yield is pretty good. Capital gains are slow but should move up in the next FY.

  • Report this Comment On May 07, 2010, at 6:21 PM, huluvu wrote:

    Seadrill pays about 9 % with a good outlook for an increease. It's the no.2 deep sea driller in the world after Transocean.

  • Report this Comment On May 08, 2010, at 7:39 AM, richardgetty wrote:

    If you need income to pay the fuel bill, 9% is better than 2%. A person needs food to live, and probably shouldn't reject bananas because they aren't oranges - they both work as food. The CEF Connect referenced above appears to give the information needed to decide on the amount of risk involved in a fund. The concept of premium/discount to NAV is good to know. OK, DPO's return is mostly from sources other than dividends received by the fund, but isn't that a GOOD thing for retail investors. The managers seem to be monetizing capital gains for us, turning gains into cash we can spend w/o a lot of individual stock trading.

  • Report this Comment On May 08, 2010, at 1:35 PM, MADMAXROI wrote:

    Regarding Gorbud's post on Verizon. Could someone please explain to me how the 6.2% yield mentioned is safe as their payout ratio is greater than 100%. How can a company continue to pay out in dividends more than they earn and have any money left over to reinvest in their business.

    Some may argue short-term fluctuations in cash flow, but in the long term, you still have an issue.

    Any insight anyone can provide here would be appreciated.

  • Report this Comment On May 08, 2010, at 2:42 PM, bullmusth wrote:

    I agree with sapereaude1: "[Mutual funds are the perfect investment tool for the ignorant and lazy.]"

  • Report this Comment On May 13, 2010, at 5:59 PM, hurls99 wrote:

    One of the best posts in a long time. Great to hear Mungers commentary. Nice job!

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1168877, ~/Articles/ArticleHandler.aspx, 10/31/2014 2:46:18 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement