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Good and Bad High-Yield Stocks

Only a few high-yield stocks are actually worth investing in.

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You often hear that stocks that pay high dividends are safe, defensive-type holdings. The conventional wisdom is that these are the kind of investments you want to hold in case the economy sputters or the stock market goes on a multiyear skid. Dividends, in this view, act as a cushion supporting the stock.

Well, I don't totally buy this argument, although I'm a fan of dividends for other reasons. The problem with the dividends-imply-safety rule is that it can lead you into some downright dangerous investments--the junk bonds of the stock universe.

If you rank stocks in Morningstar's database by dividend yield, you'll get a ragtag list of shaky investments: Argentinean oil companies, scandal-plagued energy traders, highly specialized real estate firms, and debt-laden cyclicals, among others. Using dividend yield as a proxy for low risk is dangerous--for two reasons. First, the company could be yielding a lot because it's in trouble. Eastman Kodak (EK) yields more than 4%, but it's a company that could be bankrupt in five years. In fact, if a cash-crunched company pays out dividends, those dividends could actually be speeding its demise. Second, the stock could be overpriced. For example, Ford Motor (F), Southern (SO), and Winn-Dixie Stores (WIN) are all stocks that yield more than 3%, but we think they all trade at a premium to fair value. If we're right, their high dividend yields won't save you from a poor total return. 

Haywood Kelly, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.