How to Avoid Dividend Pitfalls

As an income investor, dividends and interest are what it’s all about. But finding stocks that offer both high yields and major capital gains can be a daunting prospect.

That’s where my strategy of “cash-on-cash investing” comes in. This system looks for stocks that not only give you an immediate return on your dollars now, in the form of dividends, but also provide explosive gains down the road. In my opinion, this is the only way to build real wealth.

Here are seven secrets to successful income investing.

NEXT – Secret #1

Secret #1 – Don’t Be a Sucker for Yield

What’s the first thing you look at when considering an investment? If you said the current yield, you’re not alone. All too many income investors check the yield — and nothing else.

This is fine if you’re looking at government-insured CDs, but outside of guaranteed returns, yield alone is a tricky guide. Real estate investment trusts (REITs) are a great example. It used to be common for REITs to pay a whopping 10% or more. But some of the business practices might give you pause. With the market chaos and housing collapse, many REIT owners are now finding themselves the proud owners of a bunch of foreclosed properties generating little or no income. Get details on one REIT that’s bucking the low-yield trend here.

The bottom line: Whenever you see a juicy yield, consider the risk factor. Whether it’s default risk (the chance that the investment might not pay your money back) or market risk (the possibility the resale value of the investment might drop if interest rates go up), it pays to investigate before investing.

NEXT – Secret #2

Secret #2 – Be an Average Joe

To avoid getting sucked in by an unsustainably high yield, you need to know what a sensible yield is for the type of investment you’re considering. Generally, a below-average yield means a low level of risk, while an above-average yield indicates an added element of risk.

If you buy a stock with a current yield far above the norm for its industry, you may be inviting a possible dividend cut. On the flip side, a company with a below-average yield is likely growing faster than its peers. It may make sense for you to go with the lower yielding investment in hopes of receiving larger and faster dividend increases down the road.

NEXT – Secret #3

Secret #3 – Favor Stocks for Income Growth

For income investing, I strongly favor stocks with high and growing dividends. To determine which stocks offer the best prospects for dividend growth, I look at two major factors:

Dividend history. If a company has a long string of annual dividend increases, they’ll want to show it off and keep it up. In the midst of our recovering economy, it’s best to put your money solely into those that have avoided the perils of leverage.

Payout ratio. This is the percentage of earnings that a company pays out in dividends. For banks and industrial concerns, I like to see a payout ratio or 50% or less. Utilities are safe up to 70%, while my limit on REITs sits at 80%. (In REITs, the number to use for earnings is called “funds from operations,” or FFO).

NEXT – Secret #4

Secret #4 –
Re-Invest to Get Rich

Some income investors need their dividends and interest to survive on. If you can get by without spending your take, channel that money back into more income-rich investments. Re-investing harnesses the true power of compounding, more affectionately known as the Eighth Wonder of the World.

For example, let’s say you bought $10,000 of stocks in the S&P 500 on December 31, 1952 and made the necessary adjustments over the next 50 years to mimic the index. At the end of 2002, the portfolio would have grown to $331,100, multiplying your money 33 times.

Now let’s assume you reinvested your dividends by purchasing additional shares. By December 31, 2002, your portfolio would have skyrocketed to $1,901,700. Reinvesting would have created almost six times more wealth. Now that’s a secret worth sharing!

NEXT – Secret #5

Secret #5 –
Buy Direct and Save Big

I am a big fan of dividend reinvestment plans. Over 1,000 companies sponsor DRIPs, while many allow you to buy your first share from the issuer through so-called direct-purchase plans (DPPs). For a full listing of DRIPs and DPPs, visit www.netstockdirect.com.

Many discount brokerage firms welcome you to reinvest your dividends at little or no charge, giving you even more incentive to keep building that portfolio.

NEXT – Secret #6

Secret #6 – Lighten Up on the Mutual Funds

Mutual funds may be a common investment, but their outrageous management fees and other ongoing expenses can take a huge bite out of your paycheck. Just like salt, use mutual funds sparingly.

If you prefer the diversification and professional management of a mutual fund, I recommend Vanguard. Their operating expenses are among the lowest; Vanguard’s bond funds routinely charge less than 0.1% a year, which is only 10 cents for every $100 invested.

NEXT – Secret #7

Secret #7 – Bet on Mispriced Bets

The market often underrates the long-term prospects of some stocks, and often those are dividend stocks. A “mispriced bet” means buying a cheap stock with strong growth prospects that the market has misjudged. Of course, we can afford to be patient since we’re getting paid to wait in the form of dividends.

There are a few factors to keep an eye out for that can signal a mispriced bet. An abnormally low P/E ratio compared with the company’s projected growth is a big red flag. A strong balance sheet and competitive edge can also help rule out superficially cheap stocks that are headed nowhere fast.

Lastly, watch out for that cloud of misunderstanding. Companies trading at low valuations are often involved in some sort of legal troubles or analyst criticism, etc. If this poses a clear and present danger, book it out of there. But if I see that investors are making a mountain out of a mole hill, it’s time to pounce!

Related Articles:

• The Seven Sins of High-Yield Investing
• Mini Bonds, Maxi Yields
• 7 Ways to Get 7%
• High Yield and Safety in a REIT? Believe It!
• Top 10 Stocks to Avoid the Rest of the Year