Stocks with high dividend yields can be alluring. After all, stock prices can move sharply up -- and down -- very quickly, and getting a steady paycheck can make it much easier to ride out the downturns and not sell when the stock price drops. This is especially true if you're near or in retirement and will be counting on your stock portfolio for income.
But there are also serious risks with high-yield stocks. That's especially true in the current interest-rate environment, where a high-yield that looks too good to be true could be just that. So before you start buying the highest-yielding stocks you can find, here are a few tips that can help you not only avoid making money-losing mistakes but also make the right moves that yield thousands more than you would have otherwise earned.
You shouldn't have to stretch yourself to find big profits with high-yield stocks. Image source: Getty Images.
1. Don't buy based on yield alone
If a stock is paying a significantly higher dividend yield than the market or most of its peers, there's a good reason. However, in many cases it's not a good one. A good recent example is oil and gas infrastructure giant Kinder Morgan Inc, (KMI +0.33%), which saw its dividend yield spike to double-digit levels in late 2015 before crashing sharply in early 2016, following a 76% cut to the payout:
KMI Dividend Yield (TTM) data by YCharts
The dividend cut was only part of the story. Kinder Morgan's stock price is still down more than 30% since before the company made the dividend cut, and many investors who bought expecting a fat yield ended up selling at a big loss.
The irony is that while yield-chasers got burned pretty badly, investors who followed what was happening with Kinder Morgan were able to take advantage of the opportunity and profit. Despite the massive dividend cut, the company wasn't in trouble, but its lenders weren't going to extend it more debt, and the company needed to retain more cash to fund its growth projects. Since bottoming out in late January 2016, Kinder Morgan has generated a 70% total return for investors, significantly higher than the 56% the S&P 500 has generated over the same period.
The big takeaway? The yield is a starting point for your research, not a reason to pull the trigger.
2. Invest across multiple unrelated industries
Let's face it: Even the best business ideas can sometimes get hit by completely unexpected things. This is why owning multiple stocks is important, spreading out your risk.
But investing in multiple companies can only go so far; overexposure to a single industry can also play havoc. Using the midstream oil and gas segment as an example again, too much exposure to a group of similar stocks can burn you. Here's how Kinder Morgan and three of its peers -- ONEOK, Inc. (OKE +2.41%), Plains All American Pipeline, L.P. (PAA +1.88%), and Energy Transfer Partners LP (ETP +0.00%) -- have fared over the past three years:
KMI Dividend data by YCharts
Three of the four have cut their dividends, with only ONEOK increasing its payout. This, along with other factors, led to substantial drops in their share prices, further harming investors with too much exposure to this group of stocks. The short version is that the aggressive growth, largely funded by debt and issuing and selling stock, that these companies were pursuing when oil was over $100 and production was skyrocketing left them overleveraged and at risk of not being able meet all their financial obligations when profits fell. When this happens, the dividend is almost always the first thing to go.
Those who invested heavily in this segment could have been burned very badly. By diversifying into other industries, a downturn in one segment of your portfolio won't hurt as bad.
3. Don't risk money you can't afford to lose
When it comes to any investment, there's always some risk of losses, and the two tips above should make that abundantly clear. And while owning a diversified portfolio of dividend stocks across multiple industries will help reduce that risk, there will be short-term market drops that can drive down the value of your entire portfolio. On average, we get a 20% or greater market correction every five years or so, and a recession every decade that can bring the market down even further, and keep it down longer than the more common "correction."
Image source: Getty Images.
The big takeaway here is that it's critically important to consider your investing time frame with your portfolio dollars. If you know you'll need to sell some of your stocks to generate enough cash within the next five years or less, you're probably overexposed to stocks. This is just as true for dividend stocks as any other class. The reality is, it's almost impossible to see the next crash before it's too late to get out of the market.
And while your long-term investments can just be left invested and ride out the downturn -- while you keep collecting your dividends -- more short-term needs should be kept in cash or high-quality bonds or bond funds. You won't have the same upside potential with that money, but you also won't see the value of a stock you were planning to sell to pay the bills fall by 30% unexpectedly.
4. Know the best metrics to measure a company's dividend
As my colleague Jamal Carnette recently pointed out, it's important to use the right metric to measure whether a dividend is safe. For instance, a common measure is the payout ratio, which compares dividends per share to earnings per share, looking for a measure of safety between how much the company earns and how much it pays back to shareholders.
Image source: Getty Images.
The issue here is that not all earnings are actual cash, with expenses like depreciation and asset write downs often taking a bite out of earnings, but not actually affecting cash flows. This can make a payout ratio look artificially high. On the other hand, companies can also take advantage of non-cash items to boost earnings but not cash flows. This can make a payout ratio look better, but not necessarily mean the dividend is safer since cash flows aren't really improved. Using the payout ratio alongside free cash flows can help give a better idea if the company's cash flows are large enough to support the payout.
This is one of the reasons why some types of companies, such as real estate investment trusts -- or REITs -- are generally measured with other metrics such as funds from operations -- or FFO. This metric measures cash flows, taking into account the substantial depreciation expenses REITs take for their real estate holdings, which almost always increase in value over time, versus other capital property, such as equipment which loses value and must be replaced eventually.
5. Take the time to understand the company, not just the metrics
Investing in stocks is more than just analysis of numbers. These are companies run by people, competing against others for market share, and (hopefully) trying to increase their earnings on a regular basis. Without taking the time to understand the competitive environment, a company's strengths and weaknesses, getting a feel for its leadership (and how they are compensated), and looking at the long-term opportunity for profit growth, all the analysis of profit margins and cash flows in the world will still leave you with an incomplete picture.
Image source: Getty Images.
Taking the time to study the business itself will help you find the best opportunities, but it will also help you avoid the biggest mistakes. That alone will be worth thousands in avoided losses over an investing career -- money you'll never be able to get back and put to work.
In addition to helping you find the best high-yield dividend stocks and avoid the worst, having a strong knowledge of the company will also pay off in another way: The more you know about a company, the less likely you'll be to overreact to the market's ups and downs. To the contrary, you'll be more likely to take advantage of opportunities than sell a great business just because the market is down. That alone could be worth tens of thousands in long-term gains if it helps you stay invested in the best businesses when times seem tough.
