The Dangerous Dividend Trap

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America is a place where "more" is often considered "better."

Two pizzas for the price of one…supersized sodas (before Michael Bloomberg banned them)…suburban McMansions…

So it's no surprise that income investors focus on yield when analyzing a dividend stock. Yield is of course crucial when investing for income.

After all, it's an easy measure of how much income you'll earn from your investment. But time and time again, I see investors make the same error.

In their quest for good investment income, they put on blinders and consider only yield. The logical conclusion is that stocks with the highest yields must be the best investments.

But nothing could be further from the truth.

Many investors mistakenly focus on yields that are "high." They seek stocks paying dividends of 8%, 9% and even 10% or more. After all, the bigger the dividend, the more money they can expect to earn.

But there's one big problem. Some companies paying out these big dividends can't afford them.

Big yields often are the result of falling share prices. After all, when a stock price falls, the dividend yield will rise. And that's exactly what can make some dividends appear large.

Of course, the dividend of a falling stock is unlikely to stay high for long. There's a reason the share price fell in the first place. And those fundamentals will usually end up taking down the dividend as well.

Investors are of course advised to avoid any company that's reducing its dividend.

Let's take a look at one risky dividend stock. That company is Frontier Communications ( FTR ) , one of the highest yielding common stocks.

Frontier pays a very healthy 9% dividend - a yield that should attract lots of interest. However, a closer look reveals all sorts of problems.

Frontier is a telecom company that is primarily in the business of wired phone lines. As you know, this business is shrinking, as more consumers ditch their landline in favor of their wireless phone.

That means expansion for companies like AT&T and Verizon that have big wireless businesses. But it's a major problem for companies like Frontier.

And that's reflected in Frontier's dubious financial performance. The short story is that the company's revenues and profits are both falling. And the company's 22 cents in earnings per share won't be enough to pay its 40-cent dividend.

In many ways, that 9% dividend is a mirage. It's just a matter of time before Frontier will be forced to cut its dividend payments.

And when the dividend is reduced, plenty of investors will dump the stock. You and I know that when there is more selling than buying, share prices fall.

Now, Frontier isn't unique. There are plenty of other companies in a similar predicament. I could just as easily have talked about Windstream ( WIN ) or CenturyLink ( CTL ) - both companies are paying out unsustainable dividends.

The unfortunate fact is that many companies paying out high yields can't afford their dividend. They're living beyond their means, but are unwilling to change their ways for fear of losing investors.

My final word of warning is this…

Make sure that your dividend stocks are financially sound. If their earnings and cash flow don't cover the cost of the dividend, you could be in for a nasty surprise.

I want you to earn a healthy income from your investments. But I'm just as concerned about protecting your wealth by avoiding risky stocks. And even some "safe" dividend stocks are risky these days.

Do you own any high yield dividend stocks that may be risky?  If so, send me an email with the details. I'll be doing a reader mailbag issue of Income & Prosperity later this week, and will be happy to analyze a few top subscriber holdings. My email address is editor@incomeandprosperity.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: CTL , FTR , WIN

Wyatt Investment Research

Wyatt Investment Research

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