Some Dividend Yields Seem Too Good to Be True, Here’s How to Tell Which Ones Are

I literally wrote the definition of “sucker yields.”

Over seven years ago, I submitted it to financial dictionary website Investopedia for $50. You won’t find it there anymore, but the concept is just as relevant today as it was back then. Here’s what I mean…

No one loves a dividend-paying stock more than I do. But they’re not all created equal. Some of them might look great at first glance… but are actually hidden landmines.

Sucker yields are something you must avoid like the plague if you want to generate safe, consistent income. They’re low-quality companies with unsustainable dividends that cut their payouts, often numerous times.

I can’t count how often I’ve seen it happen… Investors will see a stock yielding high-double digits, and they’ll pile into it. But that incredibly high-dividend yield is only half the picture. And it ends up pulling the rug out from under unsuspecting investors’ feet.

In short, sucker yields are the opposite of what we look for at Intelligent Income Daily: The safest income-generating ideas to help you consistently and reliably boost your bottom line, regardless of market conditions.

So how can you tell whether a stock yielding 10%, 15%, or even 20% is a deep-value dividend stock buying opportunity or a sucker yield?

Today, I’ll bring in my number-crunching data analyst Adam Galas to show you how to tell the difference. Using two examples, we’ll lay out two methods that illustrate what makes one a true Wide Moat-style income opportunity… and the other a sucker yield trap.

Method One: What Pays the Dividends?

The reason you want to avoid sucker yields is because they can’t sustain their high dividends over time. And steadily falling dividends almost always lead to steadily falling share prices.

Likewise, when a stock yields a lot, it usually means the price has fallen… sometimes by 50% in days, sometimes languished for several years.

So it’s a sign of an unhealthy downward cycle.

The simplest way to determine whether a high-yield stock pays a sustainable dividend is to ask, “How is it paying us this dividend?”

I asked Adam to show this in action with two popular high-yield stocks. Let’s start with British American Tobacco (BTI)…

BTI has a policy of paying out 65% of earnings as dividends yearly, well below the credit rating agency safety guideline of 85%. That’s the lowest payout ratio among blue-chip tobacco companies.

It has a wide-moat, recession-resistant business that generates incredibly high margins and gobs of free cash flow. And since it retains one-third of earnings after dividends, it has plenty of money left to pay down debt, reinvest in its business, and repurchase shares.

Its 23-plus year dividend growth streak is a testament to the sustainability, dependability, and safety of the stock’s 7% yield.

Let’s contrast it with another dividend stock, the Cornerstone Strategic Value Fund (CLM). Here’s Adam again…

CLM calls itself a value closed-end fund (CEF). But when you look under the surface, owning it is actually like owning pretty much the S&P 500. It pays out 1.8% of its net assets each month to make it look like it’s offering a “20% dividend, paid monthly.”

Does CLM pay its dividends out of its cash flow? No, there isn’t much since it mirrors the S&P 500, which yields 1.6%.

For CLM’s 20% yield to be sustainable long-term, the portfolio would have to generate 20% annual returns for decades just to keep the monthly dividend stable.

Not surprisingly, almost no portfolio manager can do that – especially not one mirroring the broader market, which historically delivers 10% annual returns.

So, BTI pays its dividend from its high margins and cash flow… Meanwhile, CLM pays one that doesn’t match up with its net assets.

That’s how BTI has had a 23-year-plus dividend growth streak… and CLM cut its dividend in 14 of the last 15 years. So you can see which one offers proof of its sustainable dividends and which one is a proven sucker yield trap.

Method Two: The Wide Moat Sucker Yield Trap Test

Our second method to check if a high-yield stock is a sucker yield or a bargain-reliable dividend payer is one we’ve created at Wide Moat Research.

It tracks the long-term total returns from an initial $1,000 investment, adjusted for inflation. In this method, we assume you cash out your dividends rather than reinvest them – as is the case with most retirees who use dividend income to supplement their expenses.

So let’s see how BTI and CLM performed on this test going back 33 years…

BTI vs. CLM Returns Since 1988

(Source: Portfolio Visualizer Premium)

Over the last third of a century, $1,000 invested in CLM would have turned into $38. That’s a near complete loss. Its dividends have been falling at an annual rate of 1%.

In contrast, $1,000 invested in BTI is now worth over $4,000. Its annual dividends have grown at 8.1% for 33 years, in line with earnings and cash flows.

So despite what it looks like on the surface, digging into the details exposes sucker yields for what they are.

At Wide Moat Research, we only target safe, dependable high-yield opportunities you can trust in all economic and market conditions.

So the next time you see a stock with a dividend yield that seems too good to be true, apply these methods to get to the bottom of its story… And you’ll be able to see whether it’s a true discounted long-term income play… or a sucker yield landmine.

Happy SWAN (sleep well at night) investing,

Brad Thomas
Editor, Intelligent Income Daily