Dividend investing seems simple on its face: just pick stocks that pay large dividends to their shareholders. Yet those who just buy the highest-yielding stocks they can find often discover that they've made a big mistake. If you want to use a high-yield dividend investing strategy but don't want to leave yourself vulnerable to the traps that many dividend investors fall into, then you need to understand the dangers of high-yielding stocks and know how to spot warning signs that should make you steer clear of a particular stock. Below, you'll find three tips that can help you boost your earnings and avoid potential losses.
1. Make sure that the stock you are looking at really is a high-yield dividend stock.
As silly as it might sound in this age of instantaneously available information, the first thing you need to do in looking at a high-yield dividend stock is to make sure that the stock actually does still pay its dividend. Companies whose shares pay high yields are often vulnerable to changing financial conditions that can require them to cut or even entirely suspend their dividend payments, and that can turn what was previously a high-yield dividend payer into a low-yield or no-yield stock. Often, the high yield reflects a beaten-down share price that reflects how investors have anticipated a cut by bidding the stock downward.
It's not unusual for stocks have to cut their dividends, but what is surprising is how long it can take some sources of financial information to update their records. On numerous occasions, you can go to popular websites and still see out-of-date dividend information that fails to take into account the cut or suspended payments going forward. Before you rely on those sources, always go to the company's investor relations website, and also do an internet search on the company's name and "dividend cut" to double-check on whether the dividend is still safe.
2. See if the high-yield dividend stock you've chosen has also produced solid share-price gains.
A stock that pays a large dividend isn't automatically a good investment. Even if you're interested in current income, you always have to pay attention to the total return that a stock generates. If the share price goes down, then the money you receive in the form of dividends doesn't truly represent a positive return but rather looks more like a return of your own invested capital.
As an example, look at Frontier Communications (NASDAQ:FTR). The telecom company has a strong reputation for having and maintaining a high dividend yield, currently at 9%. However, when you look at Frontier's share price, it has steadily fallen over the past decade. As a result, those who bought shares back in 2006 have actually lost money -- even when you consider all the dividend payments they've received during that period. In general, if a company has weak fundamental business strength, then a dividend payment won't necessarily be enough to outweigh the pressure on the stock.
3. Focus on the growth potential for the dividend over time.
Similarly, looking at high dividend yields can blind you to the need for a company to have the long-term growth prospects to support rising payouts over time. The best dividend stocks are those that consistently boost their dividend payments year in and year out, allowing your income to grow and keep pace with inflation.
Sometimes, it makes sense to look at stocks with slightly lower yields but that have more potential to increase their payouts in the future. For instance, a stock that yields 3% but grows its dividend by 15% each year will catch up to a stock that currently yields 6% but has no future dividend growth potential in just five years. Often, high-growth dividend stocks will also see greater share-price increases than low- or no-growth stocks. By looking beyond today at the dividend future of a stock, you can often find bargains that other investors miss.
High-yield dividend investing can be extremely lucrative if you choose the right stocks. By following the three tips above, you'll improve your chances of picking strong performers and avoiding those stocks that eventually cut back on their dividends and disappoint their shareholders.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.