As Bank Stocks Fall… Beware of the Dividend Trap

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Monday, July 07, 2008: Issue # 816

For years, investors have bemoaned the low dividend yield on stocks. But with the market down roughly 20%, the yield on the S&P 500 is up to 2.25%. That doesn’t sound terribly rich, I know. But according to Bankrate.com, it is only slightly less than the average money market is paying right now.

In the short term, you may sleep a lot better with a big chunk of money tucked safely away in cash. But in the long run, you may lose sleep. After all, your biggest risk as an investor is not market risk – the inevitable rise and fall of your stock portfolio from week to week – but shortfall risk, the possibility that good health and steady inflation may cause you to outlive your investment portfolio.

Knowing this, many investors have been searching for higher dividends in the beaten down financial sector. This makes sense at first blush since bank stocks have fallen so far that many sport double-digit yields.

But beware. Many of these dividends will be cut sharply. Some will be eliminated altogether. That doesn’t mean that bank stocks aren’t a decent contrarian buy right now. But tread carefully…

As The Credit Crunch Ensues, Bank Earnings Evaporate

Reeling from the rise in foreclosures and the ensuing credit crunch, earnings at many banks are quickly evaporating and, in many cases, disappearing. For example:

• Citigroup has already lopped its dividend by 41%.
• National City, a major regional bank, cut its payout in half.
• And Washington Mutual slashed its quarterly dividend to a mere penny.

Seventeen of 20 financial companies in the S&P 500 have cut their dividends so far this year, more than in the past five years combined.

These banks didn’t take this step lightly. Most blue-chip banks have a long history of not cutting dividends. Management wants to keep shareholders happy. But if the money isn’t there to cover the dividend, it will not be maintained. It doesn’t make sense to borrow money – or dilute equity holders – to continue a payout.

Still, you can get a good idea which financial stocks will maintain or increase their dividends – and which ones will not – by taking a close look at the underlying business.

Two Banking Stocks - One to Consider & One to Ignore

Looking at two different banking stocks, we can see which one any dividend-oriented investor may not want to ignore. First, consider Bank of America (NYSE: BAC), for example. Here’s one of the nation’s top banks, down so far that it is yielding a mouthwatering 11.4%.

Is this stock dividend secure? Almost certainly not…

• Quarterly revenue is down 35%.   

• Earnings have slumped 77%.   

• And analysts have slashed future earnings estimates 20% over the last 90 days.

It’s just a matter of time before this dividend gets whacked.

On the other hand, take a look at Spain’s biggest bank, Banco Santander (NYSE: STD)…

• The bank has more than 13,000 branches worldwide, the most of any bank.   

• It has virtually no exposure to subprime mortgages.   

• First-quarter profit rose 37% on revenue of $11.63 billion.   

• And while many major banks are reporting record losses, Santander just reported its tenth consecutive quarter of double-digit profit growth.   

• Management is sticking to its forecast of 15% annual earnings growth over the next two years.

This 8.8% dividend yield will almost certainly rise over the next two years. Banco Santander is a far superior choice for the dividend-oriented investor.

Investment Opportunities Are Out There

There are plenty of other income and investment opportunities out there that I’ll be talking about in the weeks ahead. After all, over the past 12 months, the average company in the S&P 500 has actually raised its dividend by 9.7%.

To enjoy high total returns, you need only know where to look.

Good investing,

Alex

Today’s Investment U Crib Sheet
 
While the S&P yields 2.25%, the alternatives aren’t doing any better…

• 6-Month CD 2.99%
• 1-Year CD 3.37%
• 5-Year CD 3.96%
• Money Market 2.39%
• Savings Account 1.55%

For safety of principle, these investments are stalwarts in many portfolios and crucial for investors who need their money in less than a year. But with inflation at just over 4%, many of these are losing their appeal.

Interest rates are moving up, and inflation is rising by the month. It’s important to buy investments that will grow at least as fast. Here’s why Alex says stocks are the ultimate inflation hedge at your disposal. And here are eight investments that give you 96 dividend checks (big ones) a year.

• Hot New Spanish Model… for Banking
• Top 10 Value Traps
• Dividend-Paying Stocks: 5 Pharmaceutical “Cash Machines”

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