Resist The Temptation to Buy Any Stock With High Dividends

The Federal Reserve recently announced it will let inflation run a little hot before raising interest rates.

Which means there’s no end in sight for short-term yields locked at zero.

And as for longer-dated Treasuries, 10-year notes now yield a measly 0.66%.

That’s bad news for savers and those near retirement…

How can you generate sufficient income from your portfolio of assets?

Many have turned to stocks to generate much-needed income. Despite the risks, that can provide great opportunities to collect steady income.

But to lock in truly high yields for years to come, you have to resist this temptation…

Too Good to Be True

There are two ways to generate a high-dividend yield:

Buy a dividend-paying stock at a reasonable valuation, and one with a growth catalyst. That allows the company to increase its dividend over time.
Jump into a stock that already shows a high-dividend yield.

Many succumb to temptation and acquire stocks that already generate large dividend yields.

But simply chasing the highest yield can be a recipe for disaster. Here’s why…

Big dividend yields should be met with skepticism and plenty of research.

Quite often, an outsized yield will be the result of a cratering stock price when investors are discounting bad times ahead.

But yields are often calculated using the most recent dividend, as opposed to what is expected.

While business may have been good looking back, a high yield that’s driven by a recent drop in share price could indicate storm clouds on the horizon and an unsustainable dividend payment.

The first option takes patience. The dividend payouts may not seem very impressive at first, but your yield on cost (YOC) — the yield you receive as a percentage of what you paid for the stock — will grow over time. That’s the only yield that matters once you own shares of a stock, as Ted explained yesterday.

Let me give you an example. Suppose you picked up shares of Abbvie Inc. (NYSE: ABBV) the first month following its spinoff in 2013. The stock price per share was $36.69 at that time.

Abbvie has quickly grown its dividend since then, and now pays out $4.72 in dividends annually. On your original share cost of $36.69, that’s a dividend yield of 12.9%:

But investors can’t resist the temptation of a heavy payout.

There’s even a popular investment strategy termed “Dogs of the Dow” that was put forth by famed investor Michael O’Higgins.

Of the 30 stocks that make up the Dow Jones Industrial Average, this strategy advocates buying the 10 highest-yielding Dow stocks at the start of each year.

Dow stocks are supposed to be mature companies. They’re blue-chip bellwethers that can withstand a short-term impact on their businesses.

But on average, the “Dogs” remain down 15% this year even as the Dow itself is flat, illustrating the challenges of relying on yield alone to pick stocks … and a major flaw in O’Higgins’s strategy.

There are, however, diamonds in the rough if you know where to look … and how to apply the right set of analytics.

That’s why we follow a strict set of criteria when selecting the best opportunities for our Endless Income portfolio in The Bauman Letter.

1 Dog Worth Buying

Among the various factors under our microscope, two key measures matter most to dividends:

Payout ratio: This is how much a company pays in dividends relative to net income. A low figure points to a more sustainable dividend.
Balance sheet health: In the capital structure, paying interest to creditors takes precedent over paying dividends to shareholders. So focus on companies with a high-quality balance sheet.

When I apply that set of criteria to the Dogs, one stock in particular stands out … even though it just recently got booted from the Dow.

Pfizer Inc.’s (NYSE: PFE) dividend yield stands at 4.1% … more than double the average for the S&P 500 Index. And the company only pays out about 50% of its net income as dividends.

Pfizer also has a high-quality balance sheet. Net debt to total capital ratio is about 41%, while the company generates enough operating income to pay interest expense more than 10 times over.

And what’s more, Pfizer has more than doubled its dividend per share over the past 10 years, and it’s expected to keeping going up over the next two years.

Putting it all together, Pfizer has many of the traits we look for as an income holding.

So use this opportunity to grab an above-average dividend yield, plus grow your YOC as well.

Best regards,