Chasing Dividend Yield Into a Value Trap

In their ongoing pursuit of dividends, investors should be careful not to indiscriminately buy with only dividends in mind, according to strategists at Mellon Capital in this week’s Barron’s.

“Building a portfolio of dividend stocks needs to be carried out with precision, research insights, and a meticulous focus on underlying company fundamentals,” the article says. Dividends, they write, are an important metric to consider, but if over the past ten years an investor bought only the 20% of S&P 500 companies with the highest dividend yields, “that investor would have underperformed the index.”

Dividend yields, the article points out, rise as company shares decline. If the share price of a company with fundamentals gets battered, the yield could still appear high. This might lead the company to cut its dividend. “So, in practice,” the article argues, “it would not be uncommon to see yields rise just before being reduced or even eliminated completely.”

Chasing yields, the strategists say, can be risky. “We prefer to identify companies with strong and sustainable fundamentals, along with above average dividend yields. With so many investors seeking equity income, it’s imperative to pay close attention to valuations and to follow disciplined risk protocols.”