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 Income, every 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.

Not surprisingly, stocks without dividends had the lowest returns and the highest volatility. Non-paying stocks are often garbage and have garbage returns.

This is where it gets interesting…

The best-performing stocks aren’t actually the highest yielding ones. That distinction belongs to the next quintile down.

The highest-yielding stocks actually had lower returns and higher volatility than the next quintile down.

So, high-yield stocks — but not highest-yield stocks — tend to be the best performers over time.

Why Is the Yield So High?

As investors, we’re drawn to high yields like moths to a flame.

But incredibly appealing high dividends are generally only made possible by one of the following scenarios:

1. The stock pays out substantially all of its income in dividends and there is no possibility of significant growth. This is often true of tobacco stocks.
2. The stock is highly leveraged and, thus, at risk to any unexpected shifts in Fed policy. Closed-end funds and mortgage REITs can fall into this trap.
3. The stock is paying out a “return of capital” in addition to the regular dividend, or simply returning your original investment back to you. This is common with certain oil and gas trusts.
4. The market is pricing in a steep dividend cut and the current high yield you see is about to go up in smoke. This is a typical red flag for companies in distress.

The first, second, and third situations aren’t necessarily bad so long as you know what you’re getting into. You’ll likely lose ground to inflation over time, and that is a legitimate concern. But it’s not philosophically different than a bond.

It’s the fourth situation you really need to watch out for.

When you see an abnormally higher dividend on a stock… beware. There are times when the market just flat-out gets it wrong and a high-yielding stock is a bargain. But, more often than not, a high and rising yield is a sign of distress.

So, if you question whether a company’s dividend yield might be too high and signaling trouble ahead, a quick-and-dirty first step of your analysis should be to simply look at its dividend yield over time. If the current yield is significantly higher than in years past, something is likely amiss.

You should also give the dividend payout ratio a look.

The dividend payout ratio is the percentage of the company’s profits that it pays out in dividends. For example, if a company earns $1.00 per share and pays a dividend of $0.80 per share, its payout ratio is 80%.

As a general rule, the lower the payout ratio the better because it means the company has more of a cushion. A company payout out 100% of its earnings as dividends leaves no cash on hand for growth projects or for emergencies.

As a general rule, I like to see a payout ratio of 70% or less.

There are some caveats to this, however.

Sometimes a company has larger-than-usual write-offs that cause its earnings to get depressed in the short-term. This can make the payout ratio look abnormally high.

So, if you’re evaluating a company and you see that its payout ratio is getting awfully close to 100% (or even higher than 100%), do a little extra digging to see if the company had some sort of temporary setback. If it looks reasonable to assume that earnings will be high enough in the coming quarters to more than cover the dividend, don’t sweat it.

Also, certain types of stocks have quirky accounting that makes the payout ratio meaningless. For example, REITs and MLPs both have exceptionally high depreciation charges that depress their earnings on paper but don’t actually burn any cash. When analyzing these kinds of stocks, you’ll need to do a little extra digging. But for your typical stock, the dividend payout ratio is a simple metric to gauge how safe the dividend is, and the ratio is usually calculated for you on popular financial sites like Yahoo Finance or MarketWatch.

There’s a lot to digest here. But here’s the gist of it: Ignore the siren song of high yields when it comes to mainstream stocks and look for sustainable and, preferably, growing dividends instead.

It requires a little patience, but it’s more likely to give you safety in retirement.