If you want a good example of why naively chasing yield is a phenomenally bad income investing strategy, take a look at Whiting USA Trust (NYSE:WHX).
WHX currently sports a yield of over 99%. That's a yield that would make just about any income investor's mouth water. You get back substantially your entire investment in a single year via dividends; any residual value would be pure profit, right?
There is one big problem with that line of thought. WHX is liquidating. By the company's own estimates, it will make its last dividend payment in March of next year, after which point its value will be zero. As in literally nothing. WHX will have no assets and no residual value.
Best estimates for the dividends expected to be paid between now and next March are about $1.75 based on the amount of oil and gas assets remaining in the trust. At time of writing, WHX is trading for about $1.92 per share.
So, any investor buying WHX "for the dividend" is effectively locking in a 9% loss, and this says nothing of the taxes that would be owed on the portion of the distribution deemed to be a taxable dividend (some portion would be classified as a tax-free return of capital).
Whiting is one of those market anomalies that pop up from time to time in the small-cap universe. With a market cap of only $26 million, WHX stock is not large or liquid enough for large hedge funds and institutional traders to bother shorting it.
But before you laugh at the stupidity of anyone who would buy WHX, consider how often investors who ought to know better make phenomenally bad choices chasing yield. Two years ago, I advised readers to avoid RadioShack (NYSE:RSH), which was yielding a seductive 10% at the time. That was the right call, as RadioShack shortly thereafter slashed its dividend and went into a tailspin from which it has yet to recover.
Alas, I erred in recommending Spain's Telefonica (NYSE:TEF), which also ended up cutting its dividend. To my credit, I said any dividend cut by TEF would be temporary, and it was; the company reinitiated its dividend this year. But that is small consolation to a retiree living on a fixed income who needed the dividends to pay their bills.
So, how can we avoid falling into these sorts of traps?
First, and most obviously, do a little research on what you're buying. Whiting's website makes it abundantly clear that WHX is a liquidating entity with a terminal value of zero. You didn't need to be an accounting sleuth to find that information buried in the footnotes. Any investor who bothered to do even a superficial analysis would have immediately seen it.
Secondly, consider the dividend payout ratio, which is freely available on mainstream financial sites like Yahoo Finance. The lower the payout ratio, the better. As a general rule, I prefer companies that a paying out less than half their earnings. A stock with a ratio over 100% is consistently paying out more than earns. For certain businesses with high non-cash depreciation and amortization expenses that artificially lower net income-such as REITs and MLPs-that might be just fine. But you need to do that extra step of analysis to determine whether the company is paying out a sustainable percentage of its cash flows. If it's iffy, move on and invest your funds elsewhere. And if you're not comfortable doing this kind of analysis, you probably shouldn't be investing in the stock market.
Finally, use common sense. If a yield looks too good to be true, it probably is.
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This article first appeared on InvestorPlace.
Editor's Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.