Income investors are often older and principal preservation is their biggest priority. In investing, avoiding traps are a key way to make money. A 40% loss on one stock can wipe out a lot of 10% gains on your others. Value investors often talk about "value traps," and that concept is relevant to income investors. Here are some tips that can help you spot red flags and avoid the landmines.
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1. Understand the competition
If a stock's dividend yield is higher than its peers', it is often a danger sign that the dividend will get cut in the future. This generally happens when the business is struggling and the company doesn't have the earnings to cover it. We saw this in the spring of 2020 when Wells Fargo was yielding over 7% while its competitors were yielding around 3% to 4%. Wells eventually cut its dividend nearly in half. Whenever a high yield catches your eye, it pays to take a quick look at the company's competitors and see if the yield is way out of line. If it is, compare the annual dividend versus the earnings per share. If the dividend is higher than the earnings per share, it's a bad sign. This is a tip that might not earn you a lot, but a penny saved is a penny earned.
Take a look at the chart below, which compares Wells' dividend yield versus that of JP Morgan, Citigroup, and Bank of America.In early 2020, Wells' yield was too good to be true, and the dividend was cut in half.
WFC Dividend Yield data by YCharts
2. Understand the catalysts
The Federal Reserve has been supporting the economy by buying mortgage-backed securities (MBS) as part of its response to COVID-19. The Fed's buying is providing artificial support for the MBS market and that support will get taken away, eventually. In his prepared remarks in front of Congress, Fed Chair Jerome Powell said that ending MBS purchases was "a ways off" but is on the horizon.
In 2013, the Fed warned about cutting MBS purchases, and investors threw the asset class overboard. The difference in price for MBS relative to Treasuries fell dramatically, and with it, the stock prices of Annaly Capital and AGNC Investment. Eventually the Fed will start cutting MBS purchases, and it will announce that well ahead of time. At that point, the party is winding down. Don't stay too late.
3. Understand the macroeconomic environment
Not all stocks work over the entire economic cycle. Actually, most don't. Financials perform best when the economy is recovering from a recession, and do very poorly late in the economic cycle. The cycle for cyclicals, consumer discretionary, and defensives are all different. If the economy is strong, that is the time for consumer discretionary stocks and cyclicals. If the economy is lousy, defensives are the go-to.
Even real estate investment trusts (REITs) can vary; a net-lease company like Realty Income (O 2.70%) will perform differently than a mall REIT like Simon Property Group. Energy master limited partnerships (MLPs) will often react to oil prices.
Trying to move in and out of sectors based on your personal economic forecast is hard to do, but a periodic check of your portfolio with an eye toward the current state of the economy may pay (or prevent losses of) dividends.
