Why Dividends Ruin Your Returns

There are many reasons to own dividend stocks:

• They provide a steady (and often growing) stream of cash.
• They give you some security because of those regular paybacks.
• They instill fiscal discipline in the company's management.
• And, oh yeah, per countless studies, dividend stocks outperform non-dividend payers.

That said, dividends can ruin your returns. I'll show you how.

Learn from this terrible investor
The story starts with my dad. If he wrote an investing book, his maxims would include: "Be extra greedy when others are greedy and soil your pants when others are fearful." In short, he's a wonderful father and a terrible investor.  

I was home for the holidays, and I made the mistake of using a financial analogy to prove a point. I said something to the effect of "that would be like buying a stock just because it had a 20% dividend yield."

My point was that you have to dig past the sexy headline on investments (and other things). With every "too good to be true" investment, you have to at least identify the possible catch.

My dad stopped listening after 20% dividend yield, though.

His first question: "There are companies that have 20% dividend yields?"

My answer: "A few real estate investment trusts have dividend yields in the 15%-20% range, led by American Capital Agency (Nasdaq: AGNC), Cypress Sharpridge Investments (NYSE: CYS), and Chimera (NYSE: CIM)."

His second question/directive: "We need to buy these stocks! In five years, we've made our money back!"

My answer: "This is why Mom handles your finances."

My longer answer
My father's gut reaction is that of many investors (including me). If a 20% dividend can sustain itself for just five years, any remaining dividends or stock price is a pure return.

But there's a fundamental flaw in this logic. Many of the individual investors I talk to equate dividends with the true returns of a business. Here's why that's not true.

Dividends can (and should) flow from the cash flows derived from earnings, but there are other ways to pay out a dividend. Consider these other options. A company could pay out a dividend by:

• Draining its cash holdings.
• Selling off assets.
• Diluting your investment by issuing more shares of stock.
• Increasing its risk position by taking on more debt.

The problem here is that all of these options are temporary solutions. You eventually run out of cash and assets. Issuing more shares to pay shareholders can turn into a legal version of a Ponzi scheme. And increasing debt increases bankruptcy risk. Only long-term earnings power can sustainably fuel big dividends.

Sure, but we're only talking five years
As my dad pointed out, though, when you're talking about dividends of 20%, you don't really care if the business is around 10 years from now as long as it pays those dividends for more than five years.

Looking at the REIT example in particular, American Capital Agency, Cypress, Chimera, and their brethren are making a killing because of the government's interest rate policy. With the government keeping rates low, these REITs have been able to borrow money very cheaply and profit from large interest rate spreads on the longer-term mortgage-backed securities they buy.

And they've been paying out almost all of these profits because, as REITs, they have to to qualify for special tax treatment. Pretty sweet deal.

The problem with this is that these payouts leave REITs cash poor. If they need more funding (either to grow or to keep up interest and dividend payments), they have to sell off assets, issue more debt, or issue more stock. Which is fine when things are going well, but when they don't, REITs are extremely sensitive to interest rate movements and the health of credit markets.

And if you've paid attention to mortgage interest rates recently, you know that things can change very quickly and quite unpredictably. In short, it's no slam-dunk that American Capital Agency, Cypress, and Chimera can sustain their ultrahigh dividends for the next few years.  

But they may
These types of REITs are one of the most fascinating thought experiments in investing. To really get a handle on the situation, you have to not only make a call on the operations of these complex entities, but also make a call on the macroeconomic situation for the next few years.

There may be an opportunity out there for those who can work through these complexities, but this definitely should be in the "too difficult" bucket for my dad -- and for many of us as well.

In case these REITs do fall in that category for you, I looked for some other dividend candidates outside of the financial sector. No other stocks out there are yielding anywhere close to 20%, but I did find a handful that are yielding at least 5% and are currently easily covering those dividends with earnings. The stocks below are the only ones that made it through my screen for non-financials with market caps above $2 billion.  

Source: Capital IQ, a division of Standard & Poor's. *Payout ratio is the ratio of dividends to earnings. The lower the better.

Now, if you've been paying attention, you know you shouldn't get too excited. Just as we did with the high-yielding REITs, we can poke some holes in each of these companies.

Every investment (including each of these four) has weaknesses, but savvy investors take the time to figure out exactly what those weaknesses are and determine if the market is overreacting to them.

Meanwhile, terrible investors can take something as beautiful as high dividend yields, misuse them, and ruin their returns.

To further you on your road to being a savvy investor, we've put together a free report on dividends. In it, our Motley Fool analysts have identified 13 dividend-paying stocks that are long-term plays. To download for free now, just click here.