While high-yield stocks are often most appealing to people looking for income, they can also be excellent long-term investments to grow your wealth. At the same time, a high yield can also be a symptom of troubles with a company to be avoided, not an opportunity to make money.
Buying a stock just because it pays (or the chart makes it look like it does) a high yield can be a big mistake, if you don't know what's really happening with the business. Furthermore, you could be surprised by an unexpected tax bill with some high-yield stocks.
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On the other hand, there are some excellent growth stocks that happen to pay high-yields, too. You just have to know where to look. Let's take a closer look at three surprising facts about high-yield stocks that could put a lot of money in your pocket.
1. Sometimes that high yield is because a troubled stock is tumbling
A high-yield stock is often a company that generates substantial cash flows, and the most prudent action is to return much of it to shareholders. This can include utilities, telecom providers, midstream oil and gas companies, and other businesses with big scale and predictable recurring revenues. There are also certain kinds of companies, such as real estate investment trusts -- or REITs -- which are required to pay out most of their earnings as dividends.
But sometimes a high-yield stock is a company that's on the rocks, and its stock price has fallen substantially. In many cases, the stock price has fallen because a dividend cut is imminent, or the likelihood of a cut is very high if said company can't get its act together. Sometimes the cut has already happened, but it may not show up when you search for dividend yield (which is often calculated based on dividends paid, not future payouts).
When this happens, a company might show up on screeners as being high yield. One recent example is General Electric Company (NYSE: GE). If you were to only look at a chart of its trailing dividend yield, GE looks like a high-yield stock, right?
Not so fast. GE's yield -- on a trailing basis -- has skyrocketed, but not because the company has increased the payout. To the contrary, GE has actually slashed its dividend twice over the past year. And while all this was happening, the market has sent GE's stock down by 75%, inflating its trailing yield to high-yield proportions.
The reality is, if you bought GE today for a dividend, you'd be sorely out of luck; it only pays a penny per share per quarter. That's less than one-half of 1% yield at recent prices.
2. Some high-yield stocks come with unexpected tax consequences
All stocks aren't equal, and that's especially the case with dividend stocks. One category of stocks that is often very enticing to dividend investors are master limited partnerships, or MLPs.
What makes this legal structure compelling is that, unlike a more typical corporate structure, MLPs -- along with LLCs and "C" corps -- are known as "pass-thru" entities, which don't actually pay corporate income tax. The end result is that they can generate more distributable cash flows, making for a very efficient mechanism as an income investment.
Here's the rub: The tax man doesn't just look the other way. As a unitholder -- MLP-speak for shareholder -- in a MLP, the passed-through income may be taxed at a higher rate than the dividends you get from an "S" corporation, which are typically taxed at your long-term capital gains rate (15% for the vast majority of people). In some cases, the income you get could be taxed at your full marginal income tax rate, which could easily be 40% higher than the long-term capital gains rate.
It can get even more complicated if you're looking to invest in your retirement account. Some MLPs -- not all -- pay out distributions which are considered unrelated business taxable income -- or UBTI -- and that could lead to you owing taxes on an investment in your retirement account.
At the very least, MLPs will add some complexity to your tax preparation. Instead of a 1099-DIV, you'll get a Schedule K-1 from each MLP you own, breaking down your share of its income for the prior year.
In summary, this shouldn't dissuade you from owning MLPs; there are some very high-quality ones worth owning. Just make sure you understand the potential tax implications if you do invest.
3. High yield doesn't always mean low growth
As discussed earlier, high-yield stocks are very often in relatively low-growth industries, where returning capital to shareholders is simply the most prudent action. But that's not always the case, especially for the best-run businesses in industries with big future demand.
For instance, Brookfield Infrastructure Partners L.P. (NYSE: BIP), NextEra Energy Partners LP (NYSE: NEP), and CareTrust REIT Inc. (NASDAQ: CTRE) have more than doubled their revenues in less than four years.
Furthermore, their recent performance shouldn't be an aberration, with infrastructure, renewable energy, and healthcare housing for seniors all set for many years of high-demand growth in the years ahead.
So not only would investors get 4.6%, 3.9%, and 4.2% yields respectively at recent prices, they could likely count on regular increases in the payout for many years to come.
Jason Hall owns shares of Brookfield Infrastructure Partners and CareTrust REIT and has the following options: long January 2019 $15 calls on General Electric. The Motley Fool recommends Brookfield Infrastructure Partners. The Motley Fool has a disclosure policy.
