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I distinctly remember, as a child, how excited I was to learn that companies paid stockholders money for doing nothing. Putting dividends in a context I could understand, I was told dividends were a lot like my allowance. I now understand dividends to be one of the ways companies share their profits with shareholders, but that would have flown right over my 12-year old head.

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Dividends have occupied a warm place in my heart ever since. A few short years later, when I began managing my own small investments, I was amazed at the variety of companies I could invest in. If those companies were only viewed through the lens of one metric, it would have been clear cut which companies would likely make the best investments. All other things being equal, companies with lower P/E values or lower book values appealed to me. I also wondered why I would invest in a company paying only a 2% annual dividend, when I could instead receive a 5% annual dividend from another company. Clearly, a 5% annual dividend is better than a 2% annual dividend. I wondered if there could be anything more to investing than picking the highest dividend yield. It all seemed so simple to my young mind.

Long ago, I learned that there was much more to investing than dividend yields. In fact, a company's dividend rate is just one of many company metrics I look at when making an investment. The beginner may be tempted to only invest in the highest-yielding assets, but I contend that can be a risky approach. In fact, because dividend yields rise when stock prices fall... the very highest dividend yields are often "red flags" that a given company is on a tenuous financial footing. You may be thinking, "wait a second Income Surfer, you said you like to scout for investment ideas among companies that have recently performed the worst!". This is absolutely true, and I just wrote a post about it, but we need to be careful when doing so. Some companies have been broken (or become obsolete), and seem destine to waste away into nothing-ness. These companies are often called value traps, because they seem chronically undervalued. Despite being undervalued, they continue to lose money and decline in price.

Take a company like RadioShack (NYSE:RSH), for example. RadioShack's stock is currently trading a little over $2, but in late 2010, it traded at $20. Even more painfully, in 1999, shares of Radio Shack sold for $70 per share. I digress, however. Many times in the past few years, RadioShack has offered a fairly high dividend yield and sold for less than book value. The problem is that the company’s financial position was weak, and its customers were going to competitors. The company tried not to reduce the dividend payout as the share price fell, in the hopes that the dividend yield would entice some investors to buy. Ultimately, the company had no choice but to cut its dividend in order to preserve its capital. Today, that annual dividend sits at zero.

Another example of a very high dividend yield being a warning sign can be found in General Electric (NYSE:GE) during the financial crisis. I had purchased a few shares of GE in mid $20s (mid 2008) thinking I had gotten a huge value, because 6 months earlier, GE's shares had traded at $40. At that time, General Electric was the bluest of the "blue chips", with a 100-year track record and a history of raising dividends. As 2008 rolled on into 2009, I continued to buy GE at its ever-lower stock price. It seemed incomprehensible to me that GE would cut its dividend, but the broader market thought otherwise. (Please note, I do not believe that markets have predictive powers... but I do try to notice what investors collectively are thinking). I believe my final purchase of GE shares was around $13, with a dividend rate well over 10%. Like all things that seem "too good to be true", this one was. The stock price continued lower as GE's management slashed its dividend in order to bolster the company’s cash position. The investment has actually worked out well for me, especially because I allowed the dividends to be reinvested in additional GE shares through mid-2012. I should, however, have seen that the stock market had already priced in a massive dividend cut by GE's management.

A more recent example of a dividend warning sign can be found in the telecommunications industry. As a side note... I am bearish on the legacy telecom stocks for the reasons I list in my recent article. In mid-2010, you could have purchased shares (yielding 7%) in Verizon (NYSE:VZ) for a little less than $27. At the same time, you could have purchased shares (yielding 9%) in Windstream Holdings (NASDAQ:WIN) for about $11. You could also have purchased shares (yielding 13%) in Frontier Communications (NASDAQ:FTR) for about $7.60. Clearly, Verizon was the better-known of these companies, but it was also the more financially sound of these companies. While a mouth-watering dividend yield of 9% or 13% was very tempting in 2010, the following years didn't work out nearly so well for Windstream and Frontier investors. Check out the Yahoo Finance charts below.

Verizon

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Windstream

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Frontier

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Now you may be thinking I "cherry-picked" these examples, which is half true, but more often than not, investors price weaker companies at a discount to stronger ones (which results in very high dividend yields for the weaker companies). That is the basis of the efficient market theory, which I admit is sometimes correct (except when it isn't). Since the summer of 2010, Verizon's dividend payout and share price have both risen markedly. Windstream's dividend has held steady, while its share price is down 22% since the summer of 2010. Meanwhile, Frontier Communications has slashed its dividend by more than 50%, and the share price has been on a roller coaster ride. Hindsight is always 20/20, but examples like these are why I always invest in companies that are financially strong and growing. My capital is too precious to waste on highly speculative names. Besides, what good is a double-digit dividend yield if your principle declines by 30%.

Rule number 1: NEVER lose money. Rule number 2: NEVER forget rule number 1”

~ Warren Buffett

Reaching for yield can be a risky proposition, even within the same sector. Things get particularly hairy when investors change the asset allocation in their portfolios in order to seek out additional yield. I believe this is just what bond investors have been doing over the past 2 years, as they try to tease yield in this "yield-starved world". I am afraid many of these investors will be hit by a one-two-punch when the price of their bond (and bond proxy stocks) fall as bond yields rise. Once again, those that can least afford to suffer loses... will take it on the chin.

In a future post, I will describe the reasons why part of my portfolio is dedicated to dividend growth companies, instead of just dividend companies.

Disclosure: I am long GE. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. The information above is provided by Yahoo Finance and Nasdaq.com.

Source: The 8th Deadly Sin: Chasing Yield