The relentless hunt for higher yielding investments has seen many conservative investors look to the share market for investments that can beat the current short-term cash rates.
Many of these inexperienced investors can be lured into what appears to be a high-yielding stock without looking at the underlying fundamentals of the business.
While investors can sometimes get lucky, more often than not, when a dividend yield looks too good to be true – it usually is. I believe there are two main ways investors can be misguided by dividend yields:
- A dividend yield can look extremely high after the share price of the company has fallen significantly. Investors need to be aware that the reason for the fall in the share price might result in the dividend being reduced or even ceased.
- Broker and analyst dividend forecasts that are based on current market conditions remaining the same for the company in question. Business conditions often change rapidly and investors who are buying shares today on brokers' forecasts can sometimes be left with a large capital loss.
Here are some examples that show why investors should never buy a stock based on the dividend yield alone:
- Metcash Limited (ASX: MTS) has recently ceased its dividend for at least the next 18 months. Investors may have been expecting a dividend yield of more than 10% based on broker forecasts but instead will be left with a large capital loss and no dividend. The business has been struggling for the past few years and investors should have been cautious when Metcash started to reduce its dividend in 2014.
- Myer Holdings Ltd (ASX: MYR) has struggled under competitive pressures and rising cost growth for the past few years. The share price has come under heavy pressure and investors may have seen the high dividend yield as attractive. Unfortunately for shareholders, the share price continues to fall and the dividend is half the amount it was in 2010.
- Iluka Resources Limited (ASX: ILU) was a market favourite until 2012. The mineral sands producer was increasing production and prices for its products and it was rising strongly. At the time, brokers were forecasting a large increase in the dividend that would have been attractive to investors who had already seen impressive capital gains. Unfortunately, increased supply in the sector and reduced demand for its mineral sands products meant the commodity price fell sharply. Brokers had not been able to forecast this and the share price of Iluka more than halved in a matter of months. Needless to say, the dividend was cut and investors were left with large capital losses.
There are many more examples where investors were lured by a dividend yield that looks to good to be true and be left with large losses instead.
Foolish takeaway
Investors should always expect changes in business conditions and only invest in the best companies with a strong growth outlook. I look for companies that are growing their dividend at a steady rate and the yield they offer seems reasonable compared to the rest of the market.
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