Friday, February 8, 2008

The number one reason why i don't chase high-yielding stocks

During my early days as a dividend investor, I was focusing my attention to stocks which paid me a generous yield. I would be doing calculations, showing me that at a 10% annual yield I would be able to further compound my profits by reinvesting the dividends. One of the first stocks that I noticed was the Managed High Yield Plus Fund (HYF), a closed-end high-yield bond fund which was paying a generous 10-11% annual dividend. I bought some stock immediately, and after several weeks I received my first dividend payment, which was equal to almost a one percent return per month. I was very excited by this opportunity, which allowed me to compound my gains monthly through the regular reinvestment of dividends. The fund didn’t appreciate by much; nor did it depreciate by much. It was trading in a range, which was perfect for me - I kept receiving and reinvesting my fixed monthly payments of 5.5 cents per share.

After a while the price started decreasing, and I happily reinvested my dividends, realizing that now I would receive a higher yield for my investment at the lower prices. Instead of yielding 10%, the stock was now yielding 12%. Pretty soon though, the dividend was cut, and the yield decreased to 10% again. I was worried a little bit, but I decided that with a 10% yield I would be able to recover my losses over time even if the dividend was cut by a little bit again. For a while it did seem to me that I was going to break-even as I kept reinvesting my dividends and the price was slowly but surely climbing to the level at which I made my first investment. Then disaster strikes again - the dividend was cut and the stock fell again. I was starting to get worried, because I was getting a good yield, but my capital gains were pretty dismal. I checked the historical monthly dividend payments at yahoo finance and it seemed that the company actually had a long-term negative dividend growth. The monthly payments had been steadily decreasing ever since the fund was open for investors. In addition to that the price had been in a decline for some time. I finally realized that super high-dividend yields of over 6% annually are not sustainable in most situations. I also learned that if I would buy a stock just for the dividend payments, I should only buy companies/shares that have a solid history of raising their dividends in both bull and bear cycles over the years. In addition, the company should be a fundamentally sound business, which can afford to pay dividends even if business had a slow year. I also learned that I shouldn’t be chasing a stock simply because it offers an attractive very high yield.

The Managed High Yield Plus Fund has been trading in a range over the past 10 years assuming that you had reinvested your dividends. A $1000 investment made in late 1998, would have been worth 1280.83 by the end of 2007, which represents a 2.8% annual return. I could have achieved a much better return simply by buying CD’s, without taking on the risk of owning a volatile creature like HYF. By analyzing my trade it seems that I was chasing a stock that had increased tremendously off its 2002 lows, due to the fact that people were looking for anything that would produce any decent return on their investment, even though it had a negative dividend growth, which is a disaster waiting to happen to you. When the stock declined, I bought more. But since the dividend also declined I was buying a depreciating asset. Now I consider myself wiser – I buy stocks that show positive dividend growth. Even if the price declines I buy more, because I feel somewhat safer that the dividend is the last thing that the company would cut.

Popular Posts