The Top 7 Investment Traps to Avoid

Bryan Perry

A former Wall Street financial advisor with three decades' experience, Bryan Perry focuses his efforts on high-yield income investing and quick-hitting options plays.

High-yield securities offer great investment opportunities and returns. But there are some dangerous pitfalls. I’ll tell you the 7 biggest mistakes investors make.

The world of high-yield securities isn’t perfect. There are some dangerous pitfalls for investors who either don’t understand the risks or who are simply tempted beyond their personal discipline. Dividend investments may offer a king-sized payout, but they also can trap an investor into a strategy that’s doomed to fail in the long run.

I want to tell you about the seven biggest mistakes that income investors make. These pitfalls are worth noting when screening for any high-yield opportunity, and I recommend that you avoid these investment traps when gunning for huge dividend payouts.

Mistake #1: Buying Open-Ended Mutual Funds

This statement may come as a shock to most investors, but if there’s a choice to buy a certain index or sector closed-end fund instead of an open-end fund, opt for the closed-end fund. You can sell out of your open-end fund only at the end of the day, settling on whatever the market price is at the closing bell, which may be inconvenient with triple-digit point swings on an intra-day basis. In addition, if the market makes a big swing up, you won’t be able to get into a fund until the end of the day — not exactly an ideal way to execute a timely purchase.

Plus, let’s say the market has rallied big-time — like back in 2000 at the top of the tech bubble — and a flood of new cash shows up in an open-ended mutual fund. Well, guess what? By proxy, that fund manager has to put that money to work, chasing stocks and bonds at the peak of a rally, paying top-dollar just to be invested. Again, not exactly a winning recipe for most fund managers, but it’s a very real set of circumstances they all face with this kind of structure. By buying only closed-end funds when and where possible, you’ll have easy access to timely purchases and sales.

Mistake #2: Paying Big Premiums above Net Asset Value

Most equities trade at a premium or discount to their net asset value (NAV) for various reasons and can offer excellent investment opportunities. Locking in a high-yield payout in a discounted stock or fund can make for some exciting total returns.

What makes no sense, however, is buying into a popular name that’s trading at an enormous premium to its NAV. I can’t figure out why anyone would pay up to 25% for shares of a hot closed-end fund, for instance, when they could buy that same basket of stocks or bonds from their broker at their real market value.

Good stocks and funds that historically trade at a premium to NAV should be purchased when that premium falls under 10%. Avoid buying into anything trading at a huge premium to its NAV — and when one of your holdings pops up way above that price, it’s a good idea to evaluate whether the time is right to take profits off the table.

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One example of a stock that was trading at a high premium to NAV is Hercules Technology Growth Capital (HTGC). This business development company (BDC) was actually one of our Cash Machine holdings until it began trading at an eye-popping 40% premium to NAV and I sold it for a 59.7% total return.

As with most BDCs, understanding all that lies within its portfolio of loans to private companies is a comprehensive task. So, I let the numbers direct my actions, and in the case of HTGC I saw that revenues were expected to decline in the following quarter after missing top-line estimates in the previous one.

When it comes to the market, right or wrong, justified or not, perception is reality. At the time when I decided to sell, HTGC’s chart was showing a big trade of more than 3 million shares taking the stock down to $13 on no news. That was a red flag in my book, so given that there was still a significant premium to NAV, I believed an exit from that name was the right call.

Mistake #3: Receiving a Return of Capital

When a big, fat, juicy dividend yield is composed in whole or in part by a “return of capital,” you want to steer clear. When a fund or entity pays out a scheduled dividend payment that hasn’t been earned by profits or interest income, you can bet that a portion of that dividend will be in the form of a return of capital (ROC), which simply means that you, the investor, are getting some of your money back as part of the dividend.

Two negative things happen in this scenario. First, by getting some of your principal back, your cost basis is lowered from a tax standpoint, meaning you’ll pay more taxes when you sell that fund. Second, if a dividend is being supported by a return of capital, then you know there’s a very good chance that the underlying entity could be in trouble. Cutting a dividend payout is like a death blow to a security that was purchased for its yield.

One example is the BlackRock Enhanced Capital and Income Fund (CII). A subscriber once asked if it might be a good addition to the Cash Machine portfolios; at the time, it had an 11.5% yield and was trading at a 7.2% discount to NAV. Sounds tempting, right? Well, I dug in and found out that in the previous two quarters, the fund’s dividend had been paid primarily from ROC. That told me that CII wasn’t even close to earning its payout. In other words, this is one to be avoided for now.

Many assets only depreciate as they attempt to maintain dividend payouts that aren’t supported by real fundamentals. It doesn’t make sense to invest in an entity that’s struggling to make dividend payments as well as capital gains. Therefore, I suggest that you always avoid investments that pay out their dividends in the form of return of capital.

Mistake #4: Not Doing your Homework on Managed Distributions

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Some closed-end funds pay out what’s known as “managed distributions” as a template for their dividend policy. What happens here is that the fund, in its attempt to draw investor attention, states that it will pay out a managed distribution that’s a percentage of the NAV at the end of each quarter. Most closed-end funds that employ a managed distribution payout policy use 8% as the percentage of NAV that they peg the fund to at the end of the quarter.

The idea here is stability of income, but there’s one caveat: When the price of the fund’s shares declines, so does the managed distribution of the 8% payout. That’s because the payout is a function of the price of the NAV and not a fixed dividend like most income funds. This kind of strategy can be a big income trap for unhealthy funds, so it’s important to pay extra-close attention to the fundamentals before owning one of these.

Mistake #5: Owning Securities With High Payout Ratios

All common stocks, income trusts, master limited partnerships (MLPs), real estate investment trusts (REITs) and other pass-through entities have a payout ratio. The number shows how much of the dividend is paid out from each dollar of net income.

When screening for high yield, many entities push the envelope of the payout ratio equation to maintain their lofty dividend yields. For example, when the price of crude oil and natural gas plummeted from their summer 2008 highs, the payout ratios of many energy-related income trusts rose from the mid-50% range to more than 110% of income received.

A payout ratio above 100% is either a yellow or red flag, depending on the asset. I like to see ratios below the 85% level, assuming they’re a pass-through security such as a REIT or BDC, both of which have to pay out at least 90% of free cash flow.

A lot of commodity-based income securities will see wide fluctuations in their payout ratios; that’s the nature of dealing in the world of commodity prices. And you can live with a high payout ratio for a quarter or two. But a dividend cut is likely if the payout persists beyond six to nine months — which is exactly what happened to those energy income trusts when oil and natural gas maintained their low prices in 2009. That really can make a dent in your investments.

Mistake #6: Getting Paid in Special Dividends

A common method for paying dividends from funds that invest outside the United States is to pay “special dividends” composed of short- and long-term capital gains. The dividend policies of such funds are predicated on the ability of the fund manager to pay out whatever gains can be garnered over the course of a year, depending on short- or long-term holding periods.

Many closed-end funds based on China, India and other emerging markets had explosive returns from 2003 to 2007, racking up 50%+ returns. But a large portion of those returns were paid out in the form of huge capital-gains-based dividends and are reflected in most screening software portals in a way that suggests those funds continued to pay out gorilla-sized dividend yields. The truth is not so appealing, and the data can be hugely misleading. The bottom line: These types of funds shouldn’t be considered income vehicles in the first place.

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Mistake #7: Buying Domestic Energy Royalty Trusts

Most high-yield income investors want an energy component within their portfolio as a long-term cornerstone against inflation. That makes perfect sense, but only if that income vehicle can stand the test of time. This is achieved by replenishing reserves at a rate higher than those energy assets to the marketplace at whatever the prevailing prices are.

The main drawback of owning domestic energy royalty trusts is that they have fixed reserves, meaning that once the trust’s resources are depleted, the trust shuts down and goes out of business. You can only imagine what happens to the share price of trusts such as the Sabine Royalty Trust (SBR), a royalty trust that only has assets in oil and natural gas properties, in the long run. Sure, they get a pop when crude jumps to $100 per barrel, but eventually they run out of oil and gas to sell to the market. Domestic energy royalty trusts fail this test of time and ultimately zero out. I have gotten into some domestic energy royalty trusts right at their inception because I knew that I had several years before their supply dried up, but in general I avoid them.

Instead I prefer “gatekeeper” energy companies with a high cost of entry to their business. A perfect example of this is Cheniere Energy (LNG), which owns the Sabine Pass Terminal, the first liquefied natural gas terminal in the United States. In Cash Machine, we had had such great success with a Cheniere MLP, Cheniere Energy Partners L.P. (CQP), that I then added Cheniere Energy Partners L.P. Holdings (CQH) as the next way for subscribers to profit on the LNG story.

Coincidentally, Cheniere is in the same area as SBR, right by the Gulf of Mexico. Which company would you rather own: the one tied to the fluctuating prices of a finite resource, or the one with a virtual monopoly on that resource’s transport to energy-hungry developing nations?

Final Thoughts

Avoiding these seven investments is just part of what it takes to become a savvy high-yield investor in today’s complex high-yield income security market. It’s easy to be tempted by high-yield payouts, but as you’ve learned here, they also can be dangerous. Instead, invest in the high-yielding investments recommended in Cash Machine, all of which have passed my stringent checks and made it through my rigorous research process.

For a complete list of my holdings, be sure to check out the Cash Machine portfolio, as well as my current top buys, which are noted with blue stars in the portfolios.

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Bryan Perry
Editor, Cash Machine

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