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By Jason Stipp | 07-12-2012 04:30 PM

Watch for Warning Signs When Chasing Dividend Yield

Investors need to be aware of a stock's potential total return and avoid overpaying for a company that has an attractive headline yield, cautions Sanibel Captiva's Pat Dorsey.

Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.

Jason Stipp: I'm Jason Stipp for Morningstar. As yield seekers continue to scour the market for income, utilities and telecoms and other sorts of companies have been bid up. Surprisingly, though, some of their yields still look relatively attractive. So, are they a good bet for investors? Here to offer some insights is Pat Dorsey, president of Sanibel Captiva Investment Advisers.

Stipp: Pat, thanks for being here.

Pat Dorsey: Howdy, Jason.

Stipp: So we were looking at Verizon today; we were looking at AT&T today. The yields are not so bad, considering what you are getting elsewhere at about 5% or so. However, these stocks [have Morningstar Analyst Ratings of 1 or 2 stars] which indicates to Morningstar analysts that they are overvalued. So what should I think if I am looking for income, those yields don't look too bad, right?

Dorsey: The yields don't look too bad, certainly relative to 1.5% Treasury yield right now or a 3.5%, maybe 4% yield on an investment-grade bond. But of course, when you're buying equities you have little bit more fluctuation of principal than you do in buying bonds, and I think that's the risk in making these very tight decisions with regard to yielding equities and saying "Gee, I'd rather have the 5.5% yielding equity relative to the 4% yielding equity." Well, the thing only needs to go down 1.5% for that argument to suddenly become nil. And as we all know, the equity markets can serve up quite a lot of volatility. So, I really think as an income investor you need to think about the total return that you're going to get off a security, not just the headline dividend yield.

Stipp: So at this point because you're basically having to reach for yield or overpay for that yield right now, you are actually giving up what could be some capital gains if you had looked for an asset that was more attractively priced.

Dorsey: That's exactly right. And I think, last year for example you saw utilities up 20%, or 18% maybe. It was the single best-performing asset class in the S&P 500. Now it's not like utilities started off 2011 as dirt crazy cheap, and it's not like they grew earnings by 20%. It's because people decided to pay a lot more for them at the end of year than they did at the start of the year. That's always a little bit of a warning sign. I think that as an investor you need to be thinking about risk and the price risk you're taking, and you want to make sure you're not taking too much price risk in reaching for that higher yield.

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