A High Yield Doesn't Always Equal a High Return

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Even with payouts at relatively low levels compared with the past, dividends are very popular right now. There are numerous companies out there with astronomical yields, led by companies such as Invesco Mortgage Capital (NYS: IVR) and Chimera Investment (NYS: CIM) , both currently yielding more than 18%. As mortgage REITs, they are a part of the market's hottest dividend sector, required to pay out at least 90% of earnings as dividends every year. But these large dividends don't guarantee great returns from these stocks, and an investment in these companies could lose you money overtime.

Invesco vs. the S&P 500
The S&P 500 Index represents 500 companies of various sizes. According to IndexArb, the average estimated forward yield of the 395 companies that pay dividends from the index is 2.57%. If you include the other 105 companies, the average yield drops to 2.03%, which in and of itself isn't that bad. However, these yields pale in comparison with the 21.3% yield of Invesco, prompting many investors chasing a high yield to purchase the stock.

With the benefit of hindsight, though, we can judge how wrong those investors might have been. If you'd bought $10,000 worth of shares of three stocks a year ago -- Invesco, Hershey (NYS: HSY) yielding 2.43%, and Caterpillar (NYS: CAT) yielding 1.91%, an interesting pattern would now emerge:

Name

Initial Shares*

Initial Price (11/16/2010)

Shares Purchased Through Dividend Reinvestment / Total Price

Current Value of $10,000 Purchase and Dividends

Total Return

Invesco Mortgage450$22.2189 / $1,794.17$8,095.72(19%)
Hershey215$46.405.63 / $294.34$12,373.1324%
Caterpillar127$78.602.35 / $230.12$12,485.9725%

Sources: Yahoo! Finance and author calculations.  Current value as of Nov. 14.
*Whole shares only.

Even though you'd have more Invesco shares at the end of the year because of its higher yield, the miserable performance of the stock over that year -- along with the varying prices at which you reinvested your dividends -- would adversely affect your return. If you chose not to automatically reinvest the dividends, the initial 450 shares would be worth $6,759, a loss of 32%! Conversely, the return of the "average" companies is primarily driven by an increase in share price over the year, with both companies' share prices increasing by more than 20%.

Chimera vs. the Dow
The Dow Jones Industrial Index (INDEX: ^DJI) is made up of 30 leading companies, all of which pay a dividend. The average estimated forward yield of these 30 companies is around 3%, or about one-sixth of the current yield of Chimera Investment. The "average" company from the Dow we'll use in comparison is a refreshing one: Coca- Cola (NYS: KO) . Coke's current yield is slightly below the average at 2.76%, but for comparison's sake, it's close enough.

Name

Initial Shares*

Initial Price (11/16/2010)

Shares Purchased Through Dividend Reinvestment / Total Price

Current Value of $10,000 Purchase and Dividends

Total Return

Chimera Investment2,506$3.99423.79 / $1,506.73$7,470.97(25.2%)
Coca-Cola161$62.084.59 / $301.08$11,260.1512.7%

Sources: Yahoo! Finance and author calculations.  Current value as of Nov. 14.
*Whole shares only.

As with our previous example, a higher yield does not equal a better return, as Chimera's large price fluctuation over the year and 36% loss in share price affect its overall return. Coke doesn't have the same return as Caterpillar or Hershey, but it is truly a rule maker as the leading beverage producer. If it were to continue on the pace it established over the past year, an initial $10,000 investment would be worth $20,000 in just less than six years. That's a better proposition than losing a quarter of your initial investment, as Chimera would have done last year.

High yield can equal solid returns
Don't think that a high yield automatically equals a less-than-stellar return. In fact, I've found one company with a 20% dividend yield that puts Invesco and Chimera to shame. Like the other two, American Capital Agency (NAS: AGNC) is a mortgage REIT, and as such it's dependent on a favorable rate spread to maximize its yearly profits. Luckily for us, its spread dipped only a little in the most recent quarter, which has helped the stock maintain its value. In our purely hypothetical situation, let's see how well it would have performed for us last year.

Initial Shares*

Initial Price (11/16/2010)

Shares Purchased Through Dividend Reinvestment / Total Price

Current Value of $10,000 Purchase and Dividends

Total Return

351$28.4475 / $2,115.02$11,923.8519.5%

Sources: Yahoo! Finance and author calculations.  Current value as of Nov. 14.
*Whole shares only.

Despite a slight dip in share price over the year, American Capital would have returned nearly 20% last year, nearly in line with its lofty yield. Like my colleague John Maxfield, I am a bit wary of mortgage REITs in general, but in American Capital's case, the dividend may be too good to pass up. If I were to invest in this company going forward, I would pay close attention to quarterly reports of the changes in the all-important interest-rate spread and abandon the stock if it started to trend downward.

Other options abound
This handful of companies represents a very small percentage of the more than 2,000 publicly traded companies currently paying dividends. If you're interested in income investing, we have a new special free report titled "13 High-Yielding Stocks to Buy Today," which has 13 great-yielding stocks not even mentioned in this article. Get it while it's still available.

At the time this article was published Fool contributorRobert Eberhardlikes dividends but has no shares in any company mentioned here. Follow him on Twitter, where he goes by@GuruEbby. The Motley Fool owns shares of Coca-Cola and Chimera Investment.Motley Fool newsletter serviceshave recommended buying shares of Coca-Cola. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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