Beware Of The Dividend Trap

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 Index is up to 2.25%.

That doesn’t sound terribly rich, I know, but 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 banks aren’t a decent Contrarian’s buy right now. But tread carefully.

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 Inc. (C) has already lopped its dividend by 41%. National City Corp. (NCC), a major regional bank, cut its payout in half. And Washington Mutual Inc. (WM) 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.

Consider Bank of America Corp. (BAC), for example. Here’s one of the nation’s top banks, down so far that it is yielding a mouthwatering 7.7%.

Is this 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, there are some choice income picks overseas. Take a look at Spain’s biggest bank, Banco Santander SA (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 bank’s 4.4% yield will almost certainly rise over the next two years. Banco Santander is a far superior choice for the dividend-oriented investor.

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

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