The Lure and Dangers of High Yield Stocks (Part-1)

This article was published in the February 2013 edition of the Canadian MoneySaver, and is posted here with permission. For more information visit www.canadianmoneysaver.ca

Most investors would never buy a corporate bond yielding 10%. They would understand that a high yield in this low-interest rate environment would be a risky investment. They would likely lose some or all of their investment. But many investors who do not understand the risks of high yield, will buy dividend stocks paying 8% or 10%+ yields, double or triple what blue chips are currently paying at 3% to 4.5%. While high-yield stocks are not junk bonds, they do inherently carry much more risk than their blue-chip counterparts. Many investors simply focus on yield, not understanding the risks involved with these types of stocks. In this two-part series, I hope to illustrate some of these risks.

What is a High Yield Stock?

Wikipedia defines a high-yield stock as “a stock whose dividend yield is higher than the yield of any benchmark average. “ That’s a pretty relative measure, since many blue chip stocks have a higher yield when compared to their peers. But most investors would agree anything over a 10% dividend yield is a high yield stock. It’s the nebulous area between 5% and 10% dividend yields where investors also need to be more cautious.

I define a high-yield stock as any stock whose yield is double or higher the average in its sector. For example, Pengrowth Energy (PGF) has a current yield of 9.5%. In comparison, the current yield of the BMO TSX Equal Weight Oil & Gas ETF (ZEO) is 3.92%. As another example, AGF Management (AGF) has a current whopping dividend yield of 11.74%. In comparison, iShares S&P/TSX Financials Capped Index Fund (XFN) has a current distribution yield of 3.5%. Therefore, I consider both AGF and PGF as high-yield stocks.

As a general rule of thumb, The Ninja says:

A large-cap should never pay more than a 5% dividend yield.
A small-cap should never pay more than a 7% dividend yield.
A company with a 10%+ yield is a speculative investment.

The Lure of High Yield

The point of dividend investing is to invest in stable and profitable companies that pay a portion of their profits to shareholders. Those profits are distributed as dividends. A profitable and stable company will pay out a reasonable dividend yield and also increase that payout over time. Companies like McDonald’s (MCD) and Coca-Cola (KO) do not need to offer a high dividend yield to attract investors. Their branding and global recognition, economic moats, combined with stable earnings are their selling points.

A smaller-cap company may initially offer a higher yield to attract investors. Otherwise, no investor would want to invest in the company in the first place. Therefore, higher-yield stocks are inherently more risky from the onset. However, the higher yield is usually the result of other factors, such as a declining share price.

When you buy a company with a high dividend yield, you are taking on more risk in return for the higher yield. That’s the trade-off. If you are being paid a high yield to own a company then you will likely see less growth, more volatility in the share price, and take on all the inherent risks of owning that company. Those risks can include low profit margins, negative earnings, as well as high debt. Since they may also pay out a large portion of their earnings out to shareholders, there is little room left for dividend growth or an increase in share price. There is usually the looming threat of a dividend cut.

As mentioned previously, high-yield stocks are far more volatile, and their share price can turn dramatically on missed earnings or sudden economic shifts. We’ve seen that recently with junior oil and gas companies. As companies with high dividend yields are more vulnerable to economic shifts, they can often be hit before broad market sell-offs. This can have a big impact on your portfolio returns, when their share price suddenly plunges. Unless you understand the company and the company industry in-depth, then high-yield stocks are likely to get you in trouble more times than not. There is simply no free lunch with a high-yield stock.

Before You Back Up the Truck

Before you back up the truck on a high-yield stock that appears to be cheap or on sale, here are some red flags and questions you may want to consider:

A Crashing Share Price

Is the stock simply cheap because of a crashing share price? The price and yield of a dividend stock are inversely correlated. Therefore, as a stock price declines, the dividend yield will increase.

Dividend Yield = annual dividend per share / stock’s price per share

A declining share price is more often than not the reason for the high dividend yield (see Figure. 1 below for Pengrowth Energy). A crashing share price is also a warning sign of significant underlying issues. These can include declining sales and earnings, narrowing margins, increasing debt, or diminishing profits. It can also be a warning sign of systemic management issues and problems.

Pengrowth Energy Corp.

Figure 1. Pengrowth Energy declining share price with increasing yield (Feb. 4th, 2013).

High-yield stocks are seldom on sale because a low share price is the market’s reflection of these issues. More often than not, it’s better to sell a stock whose share price is crashing than hold on and hope for a rebound. Furthermore, a company with a declining share price and high yield will at some point need to cut its dividend. It may also continue to cut or even suspend its dividend, since it may have no other options.

High Dividend Payout Ratios

One measure to determine a sustainable dividend yield is to look at the DPR (Dividend Payout Ratio). I covered the importance of the Dividend Payout Ratio back in the July-August 2011 issue of Canadian MoneySaver. Dividend investors consider 30% to 60% as the ideal Dividend Payout Ratio. This allows companies to pay a reasonable dividend yield, meet their business obligations, and continue to expand their business and even raise the dividend. If the Dividend Payout Ratio is over 70%, and the company is not a REIT (Real Estate Investment Trust), utility, or oil and gas producer, then you should raise a red flag.

Cash Flow vs. EPS

Does the company measure out its payout ratio on cash flow instead of earnings? If so, do you know what the payout ratio is, and is it in line with its peers?  I briefly covered cash flow vs. EPS in the November 2011 issue of Canadian MoneySaver. Most of the previous Income Trusts for example, measure their payout ratios with distributable cash flow instead of earnings (EPS). REITs for example, distribute their dividends with AFFO (Adjusted Funds from Operations).

If the DPR (Dividend Payout Ratio) is 100% or more based on EPS, then the company is likely using cash flow to measure its payout ratio. I generally avoid small-cap companies that base their payout on cash flow because they are more difficult to analyze, and have more inherent risk involved.

Borrowing to Fund the Dividend

Is the company leveraging the dividend? In other words, is the company paying an unusually high dividend and borrowing money at the same time? Borrowing capital is a normal part of business and CAPEX (capital expenditures). Usually borrowing is done by issuing corporate bonds and preferred shares. However, a company which is borrowing at a rapid pace while paying a high yield is a big red flag. This may indicate that the company  cannot afford to pay its dividend, so is borrowing to make up the difference.

You can check the company releases on a website such as Yahoo Finance or the Globe and Mail to see if the company is issuing new bonds or shares.  Also be sure to check the amount the company is issuing, and compare that amount as a percentage of its market cap. Is it reasonable, or does it seem unusually high?

In Part 2, I will cover more of the risks associated with high-yield stocks…

Readers, what’s your take? Do you own high-yield stocks in your portfolio? Do you have a different take on these high-yield dividend payers?

22 Responses to “The Lure and Dangers of High Yield Stocks (Part-1)”

  1. JT

    Feb 11. 2013

    No, I don’t have any high yield stocks because the ones that I have always followed have a declining share price which becomes a prelude to major financial troubles, a cutting or suspension of the dividend, and possibly even bankruptcy. Got burned once in the late 90’s. Never again.

    Reply to this comment
    • The Dividend Ninja

      Feb 11. 2013

      Cash Flow Mantra, long time no see! 🙂

      Yes everyone at some point gets lured in by the high yield and learns the hard way. I don’t see myself wanting to get back into another high yield stock anytime soon either.

      Cheers

      Reply to this comment
  2. Dan Mac

    Feb 11. 2013

    Great article Ninja. Looking forward to part 2. I find that most of the stocks I’m interested in aren’t paying out what I would consider a high yield. I think if I saw such a high yield I would become skeptical and look into the risks more because like you said high yielding stocks generally have more risk and there is always a reason for such a high yield. In the chart above, it makes me think the high dividend will be in threat of being cut because I’m assuming that large market decline is due to a decline in earnings.

    Personally I think the best companies are the dividend growth companies. But different investing strategies work for different people. Some investors that know what they are doing can certainly profit from these high yield stocks. It’s the novice investors that don’t do the proper research that I would worry about because the high yield may draw them in and then later they will get burned.

    Reply to this comment
    • The Dividend Ninja

      Feb 11. 2013

      Hi Dan,

      PFG already cut the dividend some 43% back in July 2012. The yield was over 13% at the time I recall, and over $6.60 per share. You are right, they will have to cut the dividend again.

      http://www.cbc.ca/news/business/story/2012/07/06/pengrowth-dividend.html

      This was a stock I had from my early investing days. I bailed out on a stop loss at $6 last year.

      You are also right in that the dividend growth companies are the ones to invest in. I hope my two part series will make an investor think twice. 😉

      Cheers

      Reply to this comment
  3. writing2reality

    Feb 11. 2013

    Really nice read Ninja! While certainly I have dabled in some speculative investments, and currently hold one (PSEC), it is no doubt a minor piece of my overall picture, as my focus now shifts towards long-term, dividend growth investing.

    Looking forward to reading part two!

    Reply to this comment
  4. Dave Dineen

    Feb 11. 2013

    If you keep an eye out, sometimes market conditions do provide big bargains. I bought BMO in March 2009 at a 10.7% dividend. And it’s the TSX stock with the longest record of continuous dividend payments. A5NPObviously, that sort of opportunity doesn’t come along every day.

    Reply to this comment
  5. It’s important to understand valuation when it comes to yield. If there is a great company that has a P/E of 10, and a payout ratio of 80%, then the yield will be 8%, and it might be a great opportunity, especially if there isn’t a declining share price that looks like a value trap. If the dividend payout is less than net earnings (and not ‘cash flow’), it might be okay.

    But there are many less of these opportunities in the market today, as most of these companies have been bid up by investors. A good example is Boston Pizza Income Fund, which had a 8-9% yield last year, but now has fallen to 5.8% (but those who already owned it have seen 40% increase in capital gains).

    Reply to this comment
  6. Bet Crooks

    Feb 16. 2013

    Yes, a lot of new investors chased yield since 2009 some with disastrous results. I look at YLO as one of the scarier examples. Buyer beware!

    Reply to this comment
  7. Martin

    Feb 20. 2013

    Ninja, great post. I own one high yielding stock, currently a bit over-allocated in it, but I will be slowly unloading as the market improves. I’ll wait for part 2.

    Reply to this comment
    • The Dividend Ninja

      Feb 20. 2013

      Martin, What high yield stock are you holding?

      Cheers

      Reply to this comment
      • Martin

        Feb 21. 2013

        I hold ARR which I think isn’t that bad stock, but I am overloaded. Although recently ARR tanked I am still in positive numbers since my cost basis is pretty low, so as long as it is paying the dividend as it is, I am fine. Let’s see if they improve and stop cutting it, if not I will be unloading.

        Reply to this comment
  8. Death and Taxes

    Mar 23. 2013

    Would Penn West Petroleum be considered a risky one to own? It is paying 9% dividend and it’s share price has dropped down to the 11 dollar range. I know that most of thier product is natural gas. I am inclined to think that soft gas prices may have something to do with this as well as the cost of storage. Or would this be one to watch for future consideration? It peaked in march 2011 at 27.97 and has been on a steady decline for 2 years. I know I knowwww many people might be of the opinion “how could it go any lower” and yet others may say now is a good time to buy. However seeing how the entire market has climbed and this one is maintaining at best leaves me wondering. Am I correct in staying away from this stock?

    Reply to this comment
    • The Dividend Ninja

      Mar 24. 2013

      Hi D&T,

      Yes you should probably stay away from this company. I view it along similar lines as Pengrowth (PGF). Natural gas pricing is certainly a factor, but it is not the only consideration. I was looking at PWT when it was $14, didn’t like what I saw, and its now at $11.

      If you want to swing trade the stock maybe it’s bottomed out and is showing support at $14? You should put a stop-loss in place if you do. If you are looking for a solid long-term dividend payer there are better places to look. Husky Energy comes to mind as one holding in my portfolio where I have the utmost confidence in management.

      Cheers

      Reply to this comment
  9. Death and Taxes

    Mar 24. 2013

    Thanks DN I very much thought the same thing, glad I am on the right track!
    Yes Husky is on my list to buy as well as Enbridge,really good track record of both growth and increasing dividends.

    Reply to this comment
  10. RD

    Mar 27. 2013

    I have just dipped my proverbial toes in the water with a recent purchase of TWO ( welcome to the world of dividend investing for this newbie ). I appreciate your wisdom and see the very warnings you talk about taking place with the above mentioned REIT. It was at the time of purchase yielding 17.3% with an annual dividend of 2.20. They have since cut the yield to 9.3% and lowered the dividend to 1.28. However, it’s DPR is still sky-high at 113.2%.

    I will monitor closely and be prepared to cut quickly if/when it misbehaves. I really appreciate the education you provide . . .

    Cheers!

    Reply to this comment
    • Death and Taxes

      Mar 30. 2013

      Yes I agree with your view of Husky, definitely a long term buy and hold position. As one who works in the oil and gas sector I can also attest to the fact that they ALWAYS pay their bills very promptly and are a good company to do work for and take safety as well as quality very seriously.

      Reply to this comment

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