Don't Buy Timber REITs on Mars (and Other Stories)

Is the Great Recession really over? Warren Buffett seems to think so. And across the markets, it would appear that investors agree. Since hitting bottom just a little over one year ago, the S&P 500 has soared 65%. Retail sales are up, and credit card delinquencies down. Things are going so grand, I hear, that the Fed thinks it's safe to stop buying mortgages and unshackle the Invisible Hand of the Market. Happy days, it seems, are here again.

And if you believe all that, then I've got some prime swampland in Florida to sell you. Also, a nice bridge with a view of Brooklyn -- and perhaps, as we'll see in a moment, a great opportunity for timber investment on Mars.

Bunk and double bunk
As the Dow flirts with 11,000, investors are ecstatic at just how well the economy is rebounding. But even after adding 290,000 jobs, we're still staring down the barrel of 10% unemployment. We haven't "fixed the banks" or regulated the derivatives market that got us into this mess. And while consumer debt is down, that's mainly because a lot of the debtors have defaulted on their loans, and the banks have written off the losses.

In short, there's good news and bad news aplenty. So why are investors seeing only the former?

A tree grows on Mars
I'll answer that question in the form of a parable. Once upon a time (January 2010, to be precise), NASA sent a satellite to Mars and began taking snapshots of the Martian surface, including the one shown below:

Source: NASA.

If you're a proponent of "life in outer space," or just a fan of Edgar Rice Burroughs, chances are good that you see here what a lot of people thought they saw -- 164-foot tall pine trees growing in the Martian desert. Proof positive of life on Mars.

Problem is, that's not what the photo shows at all.

What it shows is: "dark basaltic sand pushed to the surface of sand dunes by sun-heated solid carbon dioxide ice." As the dark sand rises to the light, sandy surface, it slips down the frozen dune (think nearly horizontal movement as opposed to vertical). It's a simple trick of perspective that this looks like a tree "growing up," and opposed to sand sliding down. So ... so much for life on Mars. (This time.)

Confirmation bias
Of course, searching for life on Mars is a lot like searching for optimism in the market. Good news is what we want to see. So if the facts can be interpreted to reveal it, good news is what we do see. In the language of psychology, we're all "biased" toward seeing the facts that confirm our hopes. But while it's a familiar phenomenon, and entirely understandable, that doesn't mean investors are right to be seeing a recovery here -- or that it's safe to assume there is one.

For example, you may recall that talk of "peak oil" was all the rage just a few years ago. Goldman Sachs was predicting $200 a barrel, and the stocks of ExxonMobil (NYSE: XOM  ) and Chevron (NYSE: CVX  ) were soaring. (Why, even Warren Buffett succumbed to oil fever, snapping up shares of Exxon and ConocoPhillips (NYSE: COP  ) .)

If you bought into the Peak Oil hypothesis, then chances were good that you took Goldman's prediction as confirmation of your belief that oil stocks were going a-gusher. News that Buffett was buying these stocks would have further confirmed your "bias" in favor of high oil prices.

Problem was, it was wrong. All wrong. Never mind the dissenters warning of critical oversupply in the oil market. Never mind that the Great Recession was just around the corner, threatening to crush demand. The bull thesis went bust, and these companies have since shed anywhere from 20% to 40% of their values since those heady days of May ... 2008. (And in a final bit of irony, now that nobody's talking about $200-a-barrel oil anymore, we finally find these oil stocks selling for below-market multiples, and looking attractive.)

Which brings us to ...
"willful blindness." You don't need evidence supporting your argument if you're willing to ignore obvious flaws in the argument. Take that perpetual example of investor self-delusion: the great dividend gambit. It goes like this: You discover a stock paying an extraordinarily high dividend, say ...

Company	Dividend Yield	Payout Ratio	P/E
Windstream (NYSE: WIN  )	9.8%	137%	14.6
Penn West Energy Trust  (NYSE: PWE  )	10.0%	N/A	263.9
Linn Energy (Nasdaq: LINE  )	10.5%	N/A	N/A

You convince yourself that with a dividend this high, you're guaranteed to make money "no matter whatever the stock does." Even if the stock goes down, you're sitting pretty, collecting your 10% divvy -- and only paying 15% tax on the dividend income. Of course, before buying any of these apparent high-yielders, you need to ask yourself:

• Is this is a "real" dividend, enjoying the government's generous 15% tax rate, or a less advantageous "distribution" taxed as ordinary income?
• Is this company financially sound, and can it keep paying the dividend?
• If the dividend does go away, would you be comfortable owning the company on its own, dividend-less merits?

Every once in a while, you'll come across a high-yielder to which you can answer yes to all three questions. I'm not certain, however, that these three fit the bill. Seems to me, when a company's paying out more dividends than it collects in earnings -- or not earning anything at all -- well, that's just plain unsustainable.

What I am certain of is that the best way to avoid falling into a vanishing dividend trap is to challenge your biases, ask the necessary questions, and examine the answers with an unbiased eye. That's our goal at Motley Fool Income Investor, and if it's yours as well, perhaps you'd be interested in taking a free trial of the service? Unlike the Martian forests, that's something you can rely on. If you don't like the service, you can cancel any time in the first 30 days, no cost to you, no strings attached. Click here for more information.

Fool contributor Rich Smith does not own shares of any company named above. Check out his other holdings here, and his active Motley Fool CAPS recommendations here. The Motley Fool has a disclosure policy.