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Blindly chase fully franked dividends at your peril

Up, up and away…

The S&P/ASX 200 has charged back through 5,500, putting last week’s wobbles behind it.

US stocks are back on the up too, last week the S&P 500 enjoying its biggest climb in five months.

Step right up, Foolish investors. This bull market has some legs yet…

No surprises as far as I’m concerned.

I may sound like a broken record, but with interest rates so low, by comparison, shares paying fully franked dividends look attractive.

That said, not all stocks are created equal.

Take JB Hi-Fi Limited (ASX: JBH) for example. Yesterday its shares fell nearly 8% after the retailer revealed same-store sales slumped 5.5% in July, and forecast lacklustre growth prospects for the year ahead.

It seems consumers have stopped buying tablet computers, happy to keep using their existing products rather than upgrade. Count me in that group. My iPad2 is still going strong, whatever its retina display.

After its share price fall, JB Hi-Fi trades on a forward P/E of 13 — close to fair value given its modest growth prospects.

Where JB Hi-Fi shares get somewhat interesting is its forecast fully franked dividend yield of 4.7%, or 6.7% when grossed up for franking credits.

By comparison to term deposit rates, the JB Hi-Fi fully franked dividend yield looks attractive. Problem is, when the shares slump 8% — as they did yesterday — it wipes out the dividend attraction, and more.

Speaking of term deposits, yesterday, on behalf of my 87 year old father, I rolled over his term deposit at the princely interest rate of 3.15% for 7 months.

After tax, the uncomfortable truth for him and tens of thousands of other retirees, is term deposits are simply not keeping up with inflation. From a spending power perspective, you are losing money by holding cash.

No wonder then we’re witnessing the great dash for yield.

But there is a flip side, as witnessed by JB Hi-Fi’s painful share price fall.

Yield-hungry investors have pushed valuations up to levels that don’t leave a lot of room for error… meaning there’s now a very real chance of capital loss.

To emphasise the point, Bell Potter’s Charlie Aitken is telling clients to sell bank stocks, the AFR quoting him as saying…

“There is a monumental private investor overweight in Australian banks and my point today is I simply don’t think that bet will work, in terms of generating relative outperformance, from this point. In fact, I think it will generate relative underperformance.”

Is it finally time to sell your Australia and New Zealand Banking Group (ASX: ANZ) and Westpac Banking Corp (ASX: WBC) shares?

Australian bank shareholders have never had it so good — capital gains of 50% over the past two years, combined with growing, fully franked dividends.

It’s no wonder many investors are in love with their bank shares. The trick now for investors is to not have the 23 year old affair end in a messy divorce.

An old investor friend of mine once told me to never fall in love with a stock.

He had a rather unique and extreme deep value investing style — one that saw him usually playing amongst the dregs of the stock market.

You know the stocks — beaten down, overlooked, out of favour companies who have seen better days.

Like mining services stocks, for example.

In his latest update, Forager Funds Management’s Steve Johnson reveals 17% of his Australian Shares Fund fund is invested in a collection of businesses either directly or partially exposed to mining services.

It’s a gutsy call, that’s for sure. But Johnson has the score on the board, his fund smartly outperforming the All Ordinaries since its inception nearly five years ago.

One of the fund’s holdings — Hughes Drilling (ASX: HDX) — is up 17% today after being awarded a new drilling and blasting services contract in Western Australia.

Has the death of the mining boom been greatly exaggerated?

Not at all. But it doesn’t mean you can’t make money in the space. As ever, it’s about risk versus reward.

Hughes Drilling has a decent chunk of debt, adding to the risk profile, and doesn’t pay a dividend. But it is profitable, is aggressively paying down its debt, and trades on a P/E ratio of around 6.

So, is it a case of dumping your beloved bank shares and piling into Hughes Drilling?

Not so fast, Foolish readers.

Although the banks are more risky than the average SMSF trustee might like to want to know, they’ve got nothing on mining services companies.

That said, I’ll certainly be keeping an eye on Hughes, especially as it will be reporting results sometime this month. I like a bargain, just like you.

Speaking of reporting, Domino’s Pizza Enterprises Ltd. (ASX: DMP) unveiled another spectacular set of results today, sending its shares up 6% to almost $22.

A deep value stock it is not, trading on a P/E of 40.

Still, when you can increase your profits by 50%, same store sales for the new financial year are growing at a double-digit clip, and you can hike your fully franked dividend by 19%, a premium rating is well and truly deserved.

Domino’s Pizza is a past recommendation of Motley Fool Share Advisor, the subscription-only stock picking service I run with Scott Phillips.

Just over a year ago, we recommended our subscribers SELL Domino’s Pizza, saying we thought the company significantly overvalued, in the process locking in a 40% profit for subscribers who followed our advice.

Fast forward to today, and if we’d hung on to Domino’s Pizza, Motley Fool Share Advisor subscribers could have been sitting on a 130% profit, with potentially even more to come.

It’s true you never lose money taking a profit. It’s also true you likely leave thousands and thousands of dollars on the table when selling quality businesses, as we did with Domino’s Pizza.

Selling on valuation grounds is rarely a good move.

We got it wrong on Domino’s Pizza, but learnt our lesson with Sirtex Medical Limited (ASX: SRX), now a triple for Motley Fool Share Advisor subscribers who took our advice and bought the stock just over two years ago.

So far, bank shareholders who’ve gone the distance, reinvesting their dividends along the way, have turned modest sums of money into small investing fortunes.

Until now, not selling has been the correct decision ever since Commonwealth Bank of Australia (ASX: CBA) floated way back in 1991. No wonder it has been easy, and profitable, to love bank stocks.

What is conveniently overlooked by bank lovers is the stellar run of Commonwealth Bank shares has come during our unbroken 23-year run of economic growth, a period that has also seen house prices soar to some of the most expensive in the world.

Like we’re due a stock market correction, so Australia is due a recession. Last week’s  jump in the unemployment rate to 6.4% tells it’s own story.

It’s not that a recession is imminent, but it is a warning sign that we’re likely entering an elongated period of low economic growth, and therefore of low interest rates, much to the chagrin of term deposit holders.

On the bright side, low interest rates make fully franked dividend yields look attractive.

Up to now, buying high yielding blue chip stocks has been a one-way bet.

But the rules are changing. The easy gains have been made.

Going forward, it’s a true stock-picker’s market. Mining services stocks, anyone?

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