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The Huge Potential and Dangers of Dividends

Savvy investors still take the time to research their investments

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If you’re like a lot of your fellow investor — at least the ones who haven’t made the mistake of getting out of stocks and flocking into bonds — you’ve probably considered upping your exposure to dividend-paying stocks.

This is, after all, the mantra you hear day and night on CNBC or read in The Wall Street Journal. And you know what? As free investment advice goes, it’s surprisingly sound. Unfortunately, it’s not as simple as buying a stock with a good dividend, and I see investors making dangerous mistakes as they try to buy dividend-paying stocks.

Perhaps the biggest of all is this: focusing exclusively on the current yield. Here’s why that can be dangerous.

As you’re probably aware, the dividend yield is simply the annual dividend you receive for holding a share of a company’s stock divided by its current share price. This is useful in that it allows you to compare the dividends you receive as a shareholder to the interest you might earn from investing the same amount in a U.S. Treasury or corporate bond.

If you run the numbers like I do, this figure alone should convince you that right now is not the time to be stampeding into bonds. In fact, it may be the worst time to flee stocks I’ve seen in my 32 years investing. This is the first time I can recall, for example, when you can earn more in dividends for holding the entire S&P 500 than you can earn not only on a 10-year note, but also on a long-term 30-year government bond.

Amazingly, the exact same can be said for some of the market’s top growth stocks, including a surprising number recently flagged by my proprietary stock-selection model as offering you the best potential for market-thumping capital gains, with less volatility.

The fact that you can earn more cash income by holding the market’s most widely held stocks than you can earn on U.S. Treasuries is very important—and presents a massive opportunity. So I get why investors are interested in yield, but there are important factors to consider so you don’t get burned.

Beware Too-High Yields

Stocks are not like Treasury bonds. You receive no guarantee whatsoever that you will get your initial investment back. You also receive no guarantee that the current quarterly dividend will always be there. If you choose poorly, you can lose your capital as the stock price falls and/or your dividend can be slashed. The risk is even more acute in low-return markets like this when investors are tempted to “chase” yield. After all, in most cases, dividend yields are tantalizingly high for a reason (the stocks are cheap and rightly so)—and are simply not supported by the fundamental earning power of the business.

Investors who pile into these “over-paying” stocks thinking their dividends (and their hard-earned capital) are safe can be in for a rude awakening.

This is why I won’t recommend that you buy any dividend payer unless it satisfies my strict qualitative and fundamental criteria, is rated highly by my proprietary earnings-quality model, and passes my hands-on review of the financial statements and underlying business fundamentals.

Stock selection remains critical with dividend stocks, because if you choose them correctly, you can make a fortune both as your invested capital appreciates over the years—and as the quarterly dividend grows. This life-changing perfect storm is not possible with bonds.

The results can be stunning. Consider Coca-Cola (NYSE:KO). Master investor Warren Buffett added Coke to his portfolio less than 25 years ago. According to a recent report, the stock has earned Mr. Buffett on the order of 1,800%.

That’s fantastic, but get this: due to Coca-Cola’s commitment to consistently increase its annual dividend (anywhere from 7% to 10% per year), Mr. Buffett and his shareholders now pocket a yield of 39% on their original investment—every single year.

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