In this article, we discuss why the strong inclination among private investors to chase for yield poses major risks and how the best stock portfolio trackers can help you steer clear of them.
High dividend stocks appear to be the preferred option for many income investors, and more recently, to many members of the FIRE movement (Financial Independence. Retire Early.), to reach financial freedom. However, selecting stocks solely based on their high dividend yield can be a risky strategy. In this text, we show why investors must tread carefully when reaching for yield. In addition, we will show how the best stock portfolio trackers can help you avoid the worst pitfalls.
An entire media industry built on high yield stocks
The appeal of becoming financially independent through a meaningful recurring revenue stream from investments is so attractive that an entire media industry has built its business model on it. Newsletters, gurus and forums continuously pitch high yield dividend stock to individual investors. The result is a lot of noise, misconception and unfortunately losses on the part of private investors.
Medical Properties Trust (MPW) – A case study
When screening for high yield stocks with Ziggma’s free stock screener and sorting by yield, Medical Properties Trust, Inc. (MPW) appears high up in the list of search results over the past year or so. MPW has been one of the most frequently recommended stocks across well-known forums or investment research platforms.
Medical Properties Trust, Inc. is a real estate investment trust that acquires and develops net-leased hospital facilities. The company is one of the world’s largest owners of hospitals with 431 facilities and roughly 43,000 licensed beds in nine countries and across four continents.
Extensive drop in MPW’s stock price
Medical Properties Trust has been hit hard by the rapid rise in interest rates and the downturn in the commercial property market. Large chunks of its $10bn in outstanding debt are due to be re-financed in 2024 and 2025. As a consequence, institutional investors have turned away from the stock, driving down the stock price by 80% over the past two years. The depressed stock price in turn has driven up MPW’s dividend yield to a whopping 19%. This compares to a long term average of just 5%.
Leveraging the best stock portfolio tracker to minimize losses
With its high dividend yield, MPW has been promoted extensively by financials writers or in specialized forums. Many private investors, who heeded this advice, are sitting on huge losses on their position in MPW. In fact, its stock price would need to increase by over 400% from current levels for them to recoup their losses – even when factoring in dividend payments received.
Fortunately, some of the best stock portfolio trackers provide features for self-directed investors to pick up signs of distress early so as to avoid suffering such extensive losses.
Prominent examples of high-yield champions going bust
Sears Holding, Washington Prime and Seritage Growth Properties are well-known examples of highly promoted dividend stocks that ended up filing for bankruptcy. Their cases serve as a reminder of the complex interplay between market trends, business strategies and financial management.
Five pitfalls of chasing yield
High dividend yields might appear attractive at first glance, but they can be misleading indicators of a company’s return prospects. Investors often mistake high yields as a sign of strong profitability and stable cash flows. However, more often than not high yields are the result of a declining stock price rather than robust financial performance. These high-yielding dividend payouts almost never make up for the decline in stock price.
To stay away from high-yield dividend traps, we have compiled a list of five pitfalls when chasing yield.
1. Risk of dividend cuts
Some companies maintain high dividend yields by paying out a large portion of their earnings as dividends. These high payout ratios can prove to be unsustainable in the long run. In the case of MPW, the case for a dividend cut is obvious as the company faces a wall of debt in 2024 and 2025. Rather than paying out cash to shareholders, the company must contemplate retaining as much cash as possible to reduce the amount of financing needed from banks and the capital markets. If push comes to shove, a company that previously paid high dividends might even have to eliminate its dividend altogether.
2. Lack in growth opportunities
High dividends may be an indication of a lack of growth opportunities, or worse, a lack of strategic vision on the part of a company’s management. Companies that pay high dividends may not be reinvesting enough back into the business. This lack of reinvestment can lead to stagnation or a decline in the company’s growth prospects. A company that prioritizes dividends over business development might struggle to maintain its competitive edge, impacting its long-term profitability and viability.
3. Overlooking opportunities for value creation
Investors focused on high dividend yields might miss out on growth opportunities. Growth stocks typically reinvest earnings back into the business rather than paying dividends. By overlooking these stocks, investors might miss out on significant stock market returns.
4. Sector concentration
High dividend stocks are often concentrated in specific sectors like utilities, real estate, or consumer staples. Overexposure to a particular sector can increase the risk profile of an investment portfolio, especially if that sector faces industry-specific risks.
5. Tax inefficiency
Dividends are typically taxed at a higher rate than long-term capital gains. For investors in higher tax brackets, this can significantly reduce the net income received from dividend-paying stocks. Holding high dividend-yielding stocks in taxable accounts can be less tax-efficient compared to owning growth stocks, which are taxed only upon sale and may qualify for long-term capital gains tax rates.
Too good to be true? Get the best stock portfolio tracker to assist you
If something seems too good to be true, it’s probably because it is. So should you refrain from seeking to maximize portfolio income?
Absolutely not. Maximizing income to reach “Financial Independence Retire Early (FIRE) is a valid strategy. Many retirees depend on income from financial investments to live comfortably. They do well by seeking to maximize this income.
However, such an income maximization strategy must well executed. This is where the importance of picking the best portfolio tracker for your needs comes in to play, as we explain in our blog post “How to Pick the Best Portfolio Tracker – 10 Must-Have Features”.
Here are five ways in which a portfolio tracker can help you stay away from high dividend yield traps.
Five ways how your best stock portfolio tracker helps you avoid yield traps
1. Analyzing a company’s financial prospects
Conducting fundamental analysis will let you evaluate the prospects of a high yield dividend stock. Do not worry, you don’t have to be a professional financial analyst to uncover red flags in a high-yield dividend stock.
Look for growth. At least some growth
In order for a company to be able to sustain dividend payments, it must be growing. As part of your fundamental stock research you will want to look for revenue and income growth in a dividend stock. It doesn’t have to be much. But the company must be growing. Stay away from companies that are on the decline. They will not have the means to keep up their dividend pay-out over the long-term.
The best stock portfolio trackers in the market come with great stock research tools that make it very easy for you to verify a company’s growth prospects.
Financial strength
Another important red flag is high leverage. At one point or another financial debt has to be redeemed. If it so happens that upcoming redemptions fall into a period of high interest rates and tight debt markets, a company can quickly face financial major distress.
To evaluate a company’s financial leverage, you want to look at key leverage ratios, such as debt/equity or net debt/EBITDA, which reflects a company’s ability to service its debt from net income. Questions to ask are, how are these ratios trending, how do they compare to peers or is their suspicious volatility.
Some investors may not feel comfortable evaluating a company’s financial strength by themselves. This is not an issue, if they have picked one of the best stock portfolio trackers in the market to track their investments. These will comprise stock ratings or scores that reflect how a company fares against its peers. Within these ratings, sub-scores will reflect a company’s financial strength. This financial strength score makes it very easy for unexperienced investors to gauge whether company is on solid enough financial footing to sustain a high dividend for the foreseeable future.
2. Stock screening
An important advice concerns your stock screening. Be realistic. You want to make sure that you stay away from “too good to be true” results.
When screening by dividend yield, cap your search at a dividend yield of 13-15%. Little good has ever come out of stocks with a dividend yield in excess of this level.
If you can, stay away from small cap stocks. These may carry idiosyncratic risks that may even be outside of the most sophisticated investor’s radar.
While you’re at it, set your screen parameters for growth in revenue and income. It doesn’t have to be much, but you want to make sure that your search results comprise only companies that are growing.
Finally, the best stock screeners may even allow you to screen by financial situation. If your preferred stock screener comes with such an option, be sure to require your search results to benefit from a satisfactory financial situation.
3. Monitoring with the best stock portfolio tracker pick
Since companies’ business performance can change fast, it’s crucial to keep a close eye on it. Your portfolio companies’ ability to sustain dividends depends on it.
Monitoring business performance is standard practice among professional investors. It’s easy to implement, so we highly recommend private investors to emulate it. However, only very portfolio trackers will provide a feature to monitor business performance.
If you have managed to pick the best stock portfolio tracker which comes with such a feature, you can track your company’s key performance indicators over time. In order to have peace of mind regarding a company’s ability to pay its dividend, you want its (financial) business KPIs (key performance indicators) to improve over time, relative to their levels when you first researched and purchased the stock.
A robust monitoring process as part of your stock portfolio tracking greatly mitigates the risk of bad surprises with high-yield dividend stocks in your portfolio.
4. Consider fixed income (bond) investments
Certain stages in the economic cycle can provide for great opportunities to secure sizeable yields from fixed income investments. For much of 2023, investors had the opportunity to lock in yields of 7-8% by buying shares of bond ETFs.
As debt instruments, bonds rank well above shareholders in distribution rights and are thus much safer than equities. In addition, bond valuations are much less volatile than those of stocks. So in times of 8% yields on fixed income investments the relative attractiveness of bonds versus a similar yield from a stock strongly shifts in favor of bonds.
As an income investor, be sure to always keep an eye on the yields on offer by major bond ETFs.
5. Take market sentiment with a grain of salt
Many investors look for investment opportunities recommended by seemingly knowledgeable voices on social media or in investing forums. While there are surely some good ideas to be found, any investment idea voiced should be taken with a grain of salt. More importantly, it should be considered against the backdrop of your own financial goals or risk tolerance.
In some cases, bubbles can arise, as investors flock to certain high dividend-yielding stocks, artificially inflating their prices. Ultimately, such events end up in market corrections. In order to insulate themselves from suffering losses induced by participating in price bubbles, investors should always do their own homework and question the validity of investment recommendations.
Conclusion: A high yield portfolio can make a lot of sense. But proper portfolio, construction and monitoring is crucial.
While high dividend yield can be a part of an investment strategy, it should not be the sole criterion for stock selection. A balanced approach that considers company fundamentals, growth prospects, sector diversification, tax efficiency, and overall portfolio construction is crucial for long-term investing success.
By understanding the risks associated with high dividend yields and conducting proper fundamental research, investors can make informed long-term investing decisions that align with their financial goals and risk tolerance.
Picking the best stock portfolio tracker for one’s needs greatly facilitates this process.