street sense
Finding Safe, High-Yielding Stocks
Merck now has the highest dividend yield in the Dow Jones index. But can yield and safety go together?

By Jerry Helzner

When pharmaceutical giant Merck took its market-leading pain killer Vioxx off the market in late September due to studies that showed a correlation between Vioxx and increased risk of heart attack, Merck shares lost 27% of their value in a day. But that wasn't the end of the decline. As Merck shares continued to drop in October and November, the dividend yield on the stock reached 5.6%, the highest yield of any of the 30 stocks in the Dow Jones Industrial Average.

For some investors, this high yield represented opportunity, especially with cash dividends from common stock now being taxed at a maximum of 15%. For others, it was a clear warning sign that Merck may have to cut its dividend as part of an effort to rejuvenate its less-than-impressive drug pipeline.

In this article, I'll examine the strategy of investing in stocks for income. How can an investor obtain acceptable returns without compromising safety?

Assessing the Risk

"When the dividend on a common stock looks too attractive, there's almost always the risk that the current dividend might not be maintained," says Michael Teir, a Smith Barney financial adviser in Aventura, Fla., who specializes in finding appropriate high-yield investments for clients.

Teir says that he's currently finding stocks with reasonably safe dividends that yield in the 3% to 4.5% range. However, he cautions that common stocks now yielding above 5% probably carry some level of dividend risk.

In a previous column, I cited Altria (formerly Philip Morris) as a stock that belongs in the high yield/high risk category. Because of the huge number of lawsuits brought against Altria in recent years relating to the dangers of cigarette smoking, the company faces the possibility that one huge award could lead to a dividend cut. Some investors have been willing to take that risk, but others have steered clear, knowing that a dividend cut almost always leads to a sharp drop in the price of a company's stock.

Seeking Income with Safety

"Investors looking for a decent yield with some safety should primarily be looking at banks, some food companies and a couple of the better regional phone companies," says Teir. "But even in those categories they must be selective."

As another income idea, I'd point investors who want to spread their risk among a large number of dividend-paying companies to such exchange-traded mutual funds as Black Rock Dividend Achievers (symbol BDV). The appeal of BDV is that even if one or two of the companies in the portfolio can't maintain their dividends, the overall negative effect on the fund's returns won't be too dramatic.

But even in this area, Teir offers a warning to investors.

"A number of the closed-end income funds have been borrowing money short-term at very low rates in an effort to buy more stock and leverage their returns," he notes. "But if short-term rates continue to climb, they won't be able to use this strategy and they'll have to reduce the dividends they'll be able to pay to investors."

Investing in preferred stock offers another opportunity for high yield, but these shares don't offer the potential for price appreciation that common stock offers, and their value tends to drop in times of rising interest rates. Essentially they trade like 30-year bonds.

Ophthalmology Management Senior Editor Jerry Helzner has written more than 50 articles on stock investing for Barron's. He has been a regular stock market columnist for other business publications and was a member of the equity research department of a major regional brokerage firm. E-mail your stock market questions to him at helznergi@boucher1.com.