Dividend Bubble? That's Unpossible!

The notion that there's a "dividend bubble" has been particularly hard to kill. But let it be known: There is no dividend bubble, and it's essentially impossible for one to inflate.

Yes, that's bold.

However, I feel confident saying that because of the way we tend to think about dividends. When we discuss dividends, we're almost always talking about a stock's dividend yield, as in, "Caterpillar (NYS: CAT) has a 2.3% dividend yield."

The way dividend yield is calculated is by dividing the total amount of dividends the company pays annually ($2.08 in Cat's case) by the current stock price ($86.91 for Cat as of this writing). So if investors start going after dividends like a pack of rabid raccoons on a stinky garbage can, the stock price rises and brings down the dividend yield. In other words, the higher Caterpillar's stock goes, the less attractive it becomes from a dividend-yield perspective.

Might the rush for dividends push some stocks' valuations up a little higher than they should be? Sure, that's possible. But it's extremely unlikely that we'd see a bubble that's anything like the dot-com stocks at the turn of the millennium.

The current focus on dividends may feel like a bubble because dividends have gotten so little love in the past couple of decades. However, the mistake was the previous lack of enthusiasm for dividends -- not the current shift back toward dividend-paying stocks.

What to watch out for
This doesn't mean that investors' refocusing on dividends doesn't come with some risks. The most notable risk is the potential for investors to chase certain stocks simplybecause they have high dividend yields.

I'm a big believer in dividends and think they can say good things about a company. Notably:

  • That management recognizes that shareholders own the company and are entitled to share in the profits.

  • That management isn't holding onto lots of shareholder capital that it may waste in the future on ill-advised acquisitions or badly timed share buybacks.

  • That the company is established and profitable enough that it can afford to pay out some of its cash.

However, a dividend isn't a guarantee that any of the above are true, and it certainly isn't an automatic green light that a company is a worthwhile investment.

Dividend or not, investors still have to do their homework -- that is, understand the business they're investing in and what that business is worth. There are signs that some dividend-hungry investors aren't doing this. A great example is Great Northern Iron Ore (NYS: GNI) .

Great Northern is a land trust that's set to end in 2015. The company sports a huge dividend yield, but when I ran through some simple calculations at the beginning of 2011 it seemed highlyunlikely that investors were going to recoup their investment -- let alone earn a profit -- before Great Northern's trust ended.

While Great Northern was an egregious example of investors tripping over themselves in pursuit of dividends, there are plenty of other places where investors can get themselves into trouble. For example, there are other high-yielding trusts, e.g., BP Prudhoe Bay Royalty Trust (NYS: BPT) and its 9.9% yield, as well as a group of mortgage REITs, including Annaly Capital (NYS: NLY) and Chimera Investment (NYS: CIM) , that have been particularly popular with investors.

It's essential that investors understand the underlying businesses for all of these companies. After all, it's profit that funds the dividends. A lack of insight into the business would leave shareholders clueless about any developments that could hurt that all-important payout.

For the last time...
So, no -- there is no dividend bubble. However, as investors start to think about dividends again, there are opportunities for them to invest in bad companies or companies that they don't understand. Both are a big problem, but both have a lot more to do with laziness than anything else.

If you've zeroed in on Annaly Capital because of its huge yield and want to learn more before you buy, you'd better check out the special report from Fool analyst Ilan Moscovitz. Ilan breaks down the situation at Annaly, including "the three areas that you MUST watch." Click here to find out more about this report.

The article Dividend Bubble? That's Unpossible! originally appeared on Fool.com.

The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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