Daily Gains Letter

Do Low-Yield Stocks Provide Better Income Potential?

By for Daily Gains Letter |

Do Low-Yield Stocks Provide Better Income Potential In a high-interest environment, fixed-income assets like Treasuries, bonds, and certificates of deposit (CDs) are a staple for risk-averse investors. They provide regular investors with a stable place to park their retirement money while collecting a steady return.

By keeping interest rates artificially low, the Federal Reserve has sent income-yield-hungry investors running for the much riskier stock market. While the Federal Reserve recently hinted it might taper its $85.0-billion-per-month quantitative easing policy, investors are hardly willing to reconsider traditional fixed assets.

And why should they? Sure, it’s been six years since investors’ nerves were thrashed from the market crash and four years since the recession ended, but the economy doesn’t look or feel any different, despite the S&P 500 and Dow Jones Industrial Average touching new highs almost weekly.

For many investors nearing retirement or already retired, high-yield dividend stocks have become the new bond market. Unfortunately, some investors looking to pad their retirement account have been too heavily focused on that one solitary metric.

Not all high-yield dividend stocks are created equal. Where an investor might have avoided a stock because of red flags, today, they are considering the same stock waving the same flags, simply because they offer a strong dividend—regardless of whether or not they have enough money to do so.

Investors looking for steady capital appreciation and strong dividend growth are not usually looking for a financial roller coaster to invest in. But that’s what they’ll get if they don’t do their research.

In December 2012, Just Energy Group Inc. (NYSE/JE) was trading above $9.00 per share and paid out $1.24 annually. In February of this year, the company scaled back its annual payment to $0.84. After announcing the cut, Just Energy’s share price slipped from $9.62 to $8.05 per share overnight and bottomed near $6.00 in April.

If you invested in Just Energy back in January just because of the high dividend yield, you would have lost about 50% of your investment. While the company’s share price has rebounded, trading near $7.00, you’d still need it to climb another 22% just to break even.

It might seem obvious, but a better strategy would be to buy profitable, fundamentally strong stocks that have a strong history of reliable dividend growth and low payout ratios. Why? Because it means they have more room to grow than their mega-dividend-yielding peers.

For example, rail-based freight carrier CSX Corporation (NYSE/CSX), which has a market cap of $26.0 billion, reported record first-quarter earnings of $459 million, or $0.45 per share, and a seven-percent increase in the quarterly dividend. The company currently provides investors with an annual dividend of 2.4%, has a payout ratio of 31%, and has announced higher quarterly dividend yields for nine consecutive years. (Source: “CSX Corporation Announces Record First-Quarter Earnings, New Shareholder Distributions and Financial Targets,” CSX Corporation web site, April 16, 2013, last accessed June 3, 2013.)

Acme United Corporation (NYSE/ACU) has a market cap of $40.0 million and announced that first-quarter net income increased 19% to $309,000, or $0.10 per diluted share. The company currently pays out an annual dividend of 2.2%, has a payout ratio of 24%, and has announced higher quarterly dividend yields for nine consecutive years. (Source: “Acme United Corporation Reports 19% Increase in Net Income for First Quarter,” Acme United Corporation web site, April 19, 2013, last accessed June 3, 2013.)

Thanks to their strong financial position, these stocks have been able to provide investors with reliable earnings income and consistently increase their dividend yield. Because of their relatively low payout ratio, investors also know they will be able to continue the trend.

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