High Yield Can Be a Sign of Trouble for a Stock

DIVIDENDS ARE SUPPOSED to be something of a safe harbor when the market is in the toilet, but suspensions, reductions and yields that look too good to be true should remind income investors that every refuge has its price.

With the market spinning its wheels and short-term interest rates trudging along at a mere 2%, it's easy to see the appeal of dividends these days. There's the immediate security of regular payouts, while in the long run those dividends are critical to the healthy growth of your portfolio. Since 1926 they've accounted for more than a third of stocks' total return as an asset class.

But bear in mind there are pitfalls with chasing seemingly juicy dividends. Remember, yield represents the dividend per share divided by the stock price. That means the yield goes up as the share price goes down. Troubled mortgage giants Freddie Mac (FRE) and Fannie Mae (FNM) sport dividend yields of about 13% and 12%, respectively, but that's a function of share prices that have plunged more by more than three-quarters in the last year; those yields are not a sign of health.

Anytime you see an improbably high yield, take it as a warning sign — it usually means the market is punishing shares for good reason. Take Citigroup (C), for example. The financial giant cut its quarterly dividend by more than 40% to 32 cents a share at the beginning of the year, yet the yield still stands at nearly 7%. That's a fat return by itself, but it will be more than wiped out if the shares continue to nosedive.

Citigroup should also serve as a reminder that a company can reduce or suspend its dividend at any time. Indeed, plenty are, including big-name banks Wachovia (WB) and Washington Mutual (WM), regional bank National City (NCC) and building-products maker Louisiana-Pacific (LPX).

That reinforces the old rule of thumb that when looking for equity income, consistent dividend payers and companies with a history of raising their dividends are a better bet. For a list of such stalwarts, check out the S&P Dividend Aristocrats, a list of companies in the S&P 500 that have followed a policy of consistently increasing dividends every year for at least 25 consecutive years.

Another pitfall to avoid when looking for dividend payers is forgetting that cash is king. Earnings per share don't pay the dividend; it comes from operating cash flow. A company that consistently generates cash flow is in much better shape to fund a dividend. And don't forget to look at the balance sheet. A company drowning in debt is going to have a harder time borrowing money to fund a dividend than one with a clean slate. Finally, don't forget that unless Congress extends the rules, taxes on most dividends will likely go up in 2010.

Bottom-fishing, especially in financial stocks, has been perilous enough as it is, with new value traps seemingly born every day. Dividend payers should be part of any well-rounded portfolio, but don't get suckered by high yields. If the payout is too good to be true, it almost certainly is.

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