5 Ways To Tell If You Own A 'Dividend Disaster'

Imagine living in a world with stocks creating dividend yields of 20%, 30% or even over 40% on an annual basis. For income investors, that sounds like a dream come true -- but the truth is, these yields exist right now.

I recently searched for the highest-yielding stocks on the U.S. stock markets. I found 10 actively traded stocks that yield between 20% and close to 50% annually. My first reaction is that there must be something wrong with the data -- but these stocks actually exist. Here are three examples:

It may seem like all an investor needs to do is invest in one or more of these names and their portfolio will grow like wildfire. However, nothing is further from the truth.

Sure, several of the top 10 names will continue to pay ultra-high dividends for a while, but the dangers inherent in them are simply too high for prudent, risk-averse portfolios. Remember, a high dividend does not always indicate a successful company. Often, a high dividend yield is indicative of a plunging stock price or a failing company's last-ditch effort to attract interest. 

What's the best way to avoid a high-yielding "dividend disaster"? Here are five questions to ask before risking a penny on a high-yielder.

What is the dividend history?
How long has the company been paying dividends, and what's the trend? Have the dividends been paid for multiple years with steady upward increases, or has the company only been paying for several years in an erratic fashion? To earn a place on the SP 500's Dividend Aristocrat list, a company must have 25 consecutive years of dividend increases. Needless to say, there aren't any ultra-high-yielding stocks on this list.

​Is the company a trust?
Many ultra-high-yielding stocks are from companies organized as some type of trust. Trusts are usually required to return the vast majority of their profits to shareholders, generally through dividends.

Be sure to check the history and design of a high-paying trust. Trusts can have a finite lifespan. This means that on a certain date, the trust will be dissolved.

Unsuspecting investors who buy shares in a trust that is about to be dissolved will lose 100% of their investment. For example, the highest-paying stock I found, Great Northern Iron Ore Properties, will be dissolving in April 2015. Make certain you are aware of such critical dates before investing in a trust. The good news is, this date is always posted in advance so it's easy to avoid dissolving trusts.

In addition, real estate and mortgage trusts (known as REITs) are extremely sensitive to interest rate changes. In an environment where the only place for rates to go is higher, REITs can be dangerous. Remember, when interest rates increase, the collateral and the net asset value of the REIT declines, leading to a decrease in dividend. (My colleague Joseph Hogue recently looked at three REITs with solid, sustainable yields.)​

Is the company among the top yielders in the market?
This should go without saying, but studies have shown that on average, top-yielding stocks underperform the rest of the market.​

What's the payout ratio?
The payout ratio is the percentage of earnings paid out as dividends. In general, the lower the payout ratio, the more secure the dividend. Ultra-high-yielding stocks often have payout ratios of 100% or even higher. The higher the payout ratio, the more caution and research into the stock's fundamentals are warranted. ​

​Is the balance sheet viable?
Ask yourself if the balance sheet appears viable. Is the company mired in debt, does it have high leverage, do the liabilities outstrip assets? If the company appears to be in trouble financially yet is paying a high dividend is a classic dividend disaster soon to happen.

These five points are really just common sense. They can all be boiled down to asking, "Why are the dividends so high, and are they sustainable?" If the answer is yes, then the stock deserves greater consideration. If the answer is no, it should be avoided -- no matter the yield.​

Risks to Consider: The best rule of thumb to remember is that the higher the dividend yield, the higher the investment risk. Free lunches are very few and far between in the stock market. However, risk can be mitigated by the judicial use of stop loss orders and diversification.

Action to Take -- Take a close look at the highest yielders in your portfolio through the lens of these five questions, and be sure to use them to screen any high-yielding stocks you're thinking about buying.

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By: David Goodboy