Don’t Chase Yield

When looking at low-priced stocks, how can you tell the difference between solid value stocks and the dreaded value traps?

The answer: value stocks eventually recover, while value traps do not.

I realize that my answer is no more useful than Will Rogers’ advice — “Buy stocks that go up; if they don’t go up, don’t buy them” — and that is precisely my point.

Identifying value traps ahead of time isn’t easy.

Value traps are stocks that look cheap on paper. But rather than eventually recover to a “normal” price, they just perpetually stay cheap, or even get cheaper.

There are any number of reasons why a company becomes a value trap.

The Change into a Value Trap

Perhaps the company has an entrenched board of directors that is eroding company value.

Or perhaps a founding family has a stranglehold on the company and won’t let go.

More often than not, stocks become value traps due to crumbling fundamentals. The stock price may look cheap, but that’s only because the lousy financial results haven’t been released and the price is accurately anticipating the worst.

In the income world, value traps tend to take a very specific form, and it’s only gotten worse after nearly two decades of exceptionally loose monetary policy.

I’m referring to yield chasing.

If a 5% yield looks attractive, then surely a 10% yield is twice as attractive!

Well, it could be.

Those kinds of opportunities do pop up from time to time, and I look for them in Peak Incomeevery month. But if something looks too good to be true, you can bet that it likely is.

The numbers back this up.

Dartmouth Professor Kenneth French broke the market down into six sub-portfolios: stocks that don’t pay a dividend and then five quintiles ranked by dividend yield. He calculated the returns on each of these six buckets going back to 1928.

  No Dividend Lowest Dividend Quintile Second Lowest Dividend Quintile Median Dividend Quintile Second Highest Dividend Quintile Highest Dividend Quintile
Annualized Return 8.49% 8.90% 9.82% 9.60% 11.53% 10.54%
Standard Deviation 33.14% 22.62% 19.14% 20.57% 20.97% 23.81%
Growth of $1  $1,671  $2,546  $4,580  $5,117  $21,610  $9,757
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Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not ...

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