In today’s low-interest-rate environment, you may be tempted to seek out high-yield dividend stocks in order to get income from your portfolio. That can be a very dangerous approach to take, as a dividend that looks too good to be true may very well be in danger of getting cut.
Still, it’s possible to make money investing in higher-yielding stocks, but it’s not enough to just buy the highest dividend you can find. You have to look for solid companies that regularly generate enough cash to reward their shareholders well. These four high-yield dividend investing tips could earn you thousands by helping you steer clear of riskier stocks and focus on the ones with better prospects.
1. If it looks too good to be true, it probably is
Funeral-home purveyor StoneMor Partners (NYSE:STON) cut its dividend from $0.66 per share per quarter to $0.33 per share per quarter in 2016. While it still looks like it sports an astonishing 19% yield, the reality is that it hasn’t paid a dividend since May. In addition, the company is late filing its quarterly earnings reports, and based on what it has reported, it doesn’t look like that dividend is covered by earnings or cash flows.
Investors jumping into StoneMor Partners stock because of the headline yield may find that dividend will never materialize — or if one does show up, it may be severely reduced again. Even worse, with StoneMor’s late financials and very leveraged balance sheet, investors could see a substantial loss of their capital if the company continues to struggle.
2. Look for strong cash-generating abilities if you want large dividends
Energy-pipeline companies, such as Canadian titan Enbridge (NYSE:ENB), are in the business of moving around natural gas, oil, and related energy products. It requires a ton of upfront investment to get approvals and right-of-way authority, and to build pipelines, but ongoing operations are straightforward. The result is a “tollbooth” style business where the company collects cash today based on large investments it made in the past to build its infrastructure.
Enbridge currently yields around 5.4%, but what makes it really enticing as a dividend play is the fact that the company expects to increase its dividend by 10% to 12% annually between now and 2024. What makes that possible is a combination of the company’s tollbooth-style operations and its recent purchase of Spectra Energy. The synergies from that acquisition are expected to add to the company’s already strong cash-generating abilities to enable that dividend growth to continue.
3. Keep an eye on the balance sheet
Despite the fact that it also operates a tollbooth-style energy-pipeline business, U.S.-based pipeline-giant Kinder Morgan (NYSE:KMI) was forced to slash its dividend by 75% in late 2015. The reason was that the company had gotten so comfortable with its cash-generating abilities that it allowed its balance sheet to take on too much debt. That spooked debt-rating agency Moody’s, which threatened to downgrade Kinder Morgan’s debt to junk status.
By cutting its dividend, Kinder Morgan was able to both shore up its balance sheet and showcase its ability to fund much of its expansion plan from its organic cash flows. While that allowed the company to preserve its investment-grade debt rating, it slashed both investors’ incomes and the company’s share price. Kinder Morgan expects to begin restoring its dividend in 2018, but that’s cold comfort for investors who had depended on its high yield prior to its cut.
That cut showcases the importance of a balance sheet to a company’s ability to pay its dividend. Even a former dividend dynamo such as Kinder Morgan will cut its payment to protect its balance sheet and avoid problems borrowing cash.
4. Watch out for the tax implications of high-yield stocks
Many high-yielding stocks pay high dividends because they have to, either by law, or to attract investors. Real estate investment trusts (REITs), for instance, must pay out at least 90% of their earnings in the form of dividends, but in exchange, they don’t pay taxes at the corporate level. Similarly, publicly traded partnerships don’t necessarily have to pay out their earnings as dividends, but their partners are taxed on the partnership’s earnings regardless of whether they receive dividends.
The advantage of those structures is that they avoid the “double taxation” of earnings — once at the corporate level and once at the shareholder level. The disadvantage, however, is that those dividends are often not considered “qualified,” and thus investors are forced to pay their full marginal tax rates on the income they earn. In the case of partnerships, that often includes paying state taxes in states the investor would otherwise not have to deal with.
Business first, dividend second
Ultimately, any company worth investing in has the financial and operational strength to support its operations and its dividend, regardless of where that dividend gets set. As a dividend takes capital out of the company in order to provide that payment to shareholders, it’s particularly important for investors to keep an eye on the financial health of their higher-yielding investments.
A strong business that rewards its shareholders with a generous dividend can be a wonderful investment. A weak business that pays out more than it can afford, on the other hand, is likely a terrible investment, no matter how juicy its yield appears on the surface. When looking for high-yield stocks, keep that in mind, and you’ll improve your chances of being rewarded for the risks you’re taking.
Chuck Saletta owns shares of Enbridge and Kinder Morgan and has the following options: long January 2018 $17.50 calls on Kinder Morgan and short January 2018 $17.50 puts on Kinder Morgan. The Motley Fool owns shares of and recommends Enbridge, Kinder Morgan, and Moody’s. The Motley Fool has a disclosure policy.
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