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It’s important to understand that if the company’s revenues and earnings are growing, the dividend will also likely rise.denphumi/Getty Images/iStockphoto

Why would you list such crappy yielding stocks in your column? 1.8 per cent to 3.8 per cent? I just bought a bunch of Royal Bank preferreds (series BI) yielding 4.9 per cent – still no great shakes but a whole lot better than 1.8 per cent.

Whenever I write about dividend stocks with modest yields, as I did in my Yield Hog column last week, invariably I get complaints like the one above.

Today I'll respond to the reader's e-mail (one of several I received that made a similar point) because it reflects some common misconceptions about dividend stocks.

First, the reader dismisses the stocks as "crappy" based on a single criterion – the yield. Based on this reasoning, which is all too common among retail investors, every stock with a low yield is to be avoided and every stock with a high yield is desirable.

But this is a flawed – and potentially dangerous – assumption. Plenty of stocks with modest yields have produced fabulous long-term returns. Shares of Enbridge, for example, were yielding about 3 per cent 10 years ago. Since then, the dividend has grown at an annualized rate of about 13 per cent, and the share price has roughly tripled on a split-adjusted basis.

Result: $10,000 invested in Enbridge 10 years ago would be worth nearly $40,000 today, assuming all dividends were reinvested.

If you'd given Enbridge a pass based on its modest yield, you would have missed out on some very attractive gains (disclosure: I own Enbridge shares both personally and in my Strategy Lab model dividend portfolio.)

When assessing a stock, it's important to remember that the total return comes from two sources: dividends and capital growth. It's also important to understand that if the company's revenues and earnings are growing, the dividend will also likely rise. So a dividend that looks small initially can become substantial after years of compound growth. Canadian National Railway's dividend, for example, was just 6.75 cents (split-adjusted) in 1996; it's now $1.25 – an increase of 1,750 per cent.

Many investors are drawn to stocks with large current yields, but these aren't necessarily slam dunks. In fact, a high yield can be a danger sign: TransAlta, Yellow Pages and AGF all sported enticingly fat yields, but they eventually cut their dividends and their share prices plunged. Similarly, many energy producers had double-digit yields, but the payouts couldn't be sustained in the face of plunging oil prices.

So, you have to look at much more than the yield to know whether a stock is a good investment – or an accident waiting to happen. Are revenues and earnings rising? Is the yield low because the company is plowing cash back into the business to grow? Is the balance sheet strong? Is the dividend payout sustainable? Is the dividend likely to grow? Choosing a stock based on yield alone is like picking a horse to win because you like its name.

While it's true that Royal Bank preferred shares series BI (ticker: RY.PR.O) have a higher current yield than the stocks mentioned in the column, that doesn't necessarily make it a superior investment. Unlike a common share, RY.PR.O's dividend is fixed – it is not going to grow. Nor is there much potential for capital appreciation with preferred shares in general, whose prices are affected by interest rates and the credit quality of the issuer.

This is not to suggest RY.PR.O is a bad investment; as long as Royal Bank doesn't get into serious financial trouble, the dividend should be safe. But comparing the higher yield of a preferred share that has a fixed dividend to the lower yield of a common share that offers the potential for dividend and capital appreciation is an apples-to-oranges exercise.

In my own portfolio, I generally focus on common stocks with yields ranging from about 3 to 5 per cent (slightly higher or lower in a few cases) and which have a high probability of increasing their dividends for many years. These include utilities, pipelines, power producers, banks, real estate investment trusts, telecoms and large consumer stocks. I would rather accept a modest yield now, with the potential for growth in both the dividend and share price, than a higher yield that comes with additional risk or poor growth potential.

With yields, sometimes good things come in small packages.

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