The Lure and Dangers of High Yield Stocks (Part-2)

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

In my article for the February issue of Canadian MoneySaver, I discussed The Lure and Dangers of High Yield Stocks (Part-1).  I covered some of the reasons why investors are lured into high-yield stocks, and some of the pitfalls that can occur if investors are not careful.

Here is a quick recap.

So what exactly is a high-yield stock?  As I covered in my previous article, most investors would agree any stock that yields over 10% is a high-yield stock.  I also defined a high-yield stock as any stock with a dividend yield double or triple the average in its sector (see previous article).

The Ninja says a large-cap stock should never pay more than a 5% dividend yield, and investors also need to be careful with a dividend stock which yields 5% to 10%.  A company with a 10%+ dividend yield is a speculative investment.  I also covered some of the reasons why high-yield stocks are seldom on sale, and why a lower share price may not indicate a bargain.  These reasons are primarily a crashing share price, high dividend payout ratios, and the possibility the dividend may be funded through debt.

Here are a few more considerations to take to heart when looking at buying a high-yield stock:

Value Play vs. Value Trap

As previously mentioned, a crashing share price is more often than not the reason why a high-yield stock appears to be cheap.  Since yield and price are inversely correlated, a high dividend yield may simply be the result of a declining share price.  This in itself should be a red flag to investors that there could be trouble down the road.

A big blue-chip company that is going through a rough patch, and being oversold, may indeed be a value play.  But high-yield stocks are seldom on sale.  They may have high debt, declining sales and declining profit margins, and even decreasing cash flow.  When a company finds itself in this situation, and continues to offer a high yield, you can be certain a dividend cut is looming.  High-yield stocks which appear to be value plays are more often than not low-priced value traps.

Yield vs. Growth

One of the mistakes investors make when starting out is assuming a high yield is a high return.  As an investor you have to realize that if you are being paid a high dividend yield, there has to be a trade-off.  A company which is placing all or most of its earnings and profits into a dividend cannot put money back into the business.  In other words, they can’t grow the business.  Eventually, this will reflect on the share price of the company, more often than not, as a declining share price.  That decline can easily offset any high-yield dividends you were originally being paid.  That’s the trade-off.

Stability of Growth

When you invest in a stalwart blue-chip like Johnson & Johnson (JNJ), you do so knowing your dividend is guaranteed.  You also know that JNJ will continue to offer a consistent and stable dividend year after year, and even increase the dividend.  A company like JNJ can afford to increase the dividend primarily because it has stable and growing earnings.  It also has a reasonable dividend payout-ratio (currently at 63%), so retains a generous portion of capital to reinvest into the business.  Most established blue chips will pay their dividends from cash.  This creates both stability and growth.

The opposite may happen with high-yield stocks.  The dividends are neither guaranteed nor stable.  With high payout ratios, the companies are not in a position to raise the dividend.  The company must borrow (get into debt) to expand or grow their business.  Some may even borrow to pay the dividend. Additionally, their earnings (EPS) and margins can be unstable, and shift dramatically from year to year. If you’re looking for long-term and stable growth in your portfolio, then high-yield stocks are the wrong place to look.

Variable Dividend Policies and Dividend Cuts

Does the company have a variable dividend policy?  Has the company cut its dividend in the past?  Many of the previous income trusts in Canada, as well as most junior oil and gas producers, do have a variable dividend policy.  While such a policy is not a deal-breaker, it does mean the company is not guaranteeing a consistent dividend.  It also implies management may lower or raise the dividend at their discretion, or even cut the dividend.

A variable dividend policy means you are unlikely to see a stable or growing dividend for the long-term, as it runs the risk of being cut in hard times.  That can lead to volatility in both the share price and the dividend yield.  A company with a variable dividend policy is the wrong place to look for the stable growth of your portfolio.

Conclusion

While having a few high-yield dividend payers in your portfolio can boost returns, and provide income, you do need to be aware of the risks involved.  The predominant risks are dividend cuts and a crashing share price.  High-yield stocks require much more due-diligence and monitoring, and they are seldom on sale.  I hope this two-part series made you aware of the questions you need to ask before hitting the ‘Buy’ button.

If you missed Part-1, be sure to read it here:  The Lure and Dangers of High Yield Stocks (Part-1).

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?

10 Responses to “The Lure and Dangers of High Yield Stocks (Part-2)”

  1. I think your threshold of 10% is fair. I have invested in many companies with yields in the 7-8% range, but only after careful fundamental analysis. Dividend Payout Ratio is one of the best screening criteria to eliminate trouble stocks – but always use net earnings, not cash flow, to assess sustainability of the dividend.

    Reply to this comment
    • The Dividend Ninja

      Mar 25. 2013

      Hey CDB,

      Thanx for dropping by. Most of the companies in the 7% to 8% range are either REITs or many of the previous income trusts. The yields are higher, as you know, since taxation is passed onto the unit holder instead of the corporation paying the tax.

      Most of these companies use cash flow to distribute their earnings, i.e. Adjusted Funds From Operations (AFFO) or a measure of Distributale Cash Flow (DCF). They don’t normally base their payouts on earnings, but on distributable cash flow.

      Therefore they are much more difficult to analyze. For example, oil producers have huge amounts of depreciation from the oil-drilling equipment, and REITs also have massive depreciation through their properties. This is why a standard payout ratio with earnings (EPS) doesn’t mean much, it will usually be over 100%.

      So I’m curious how you would analyze earnings rather than cash flow, considering the impact (or not) of depreciation on earnings. Just curious, so asking. ;)

      Cheers
      The Dividend Ninja

      Reply to this comment
  2. Dan Mac

    Mar 25. 2013

    Great conclusion to the High Yield dangers series. I’m pretty conservative in my investing and haven’t purchased anything yielding much over 5% really. I wouldn’t mind finding a great company yielding something higher if I could be sure it was sustainable. However for my portfolio I haven’t found anything I’ve been interested in yet.

    Reply to this comment
    • The Dividend Ninja

      Mar 25. 2013

      Hi Dan,

      I agree. If you are primarily interested in “dividend-growth”, then it would be pretty hard to find many of those kinds of companies yielding more than 5%. You’d have to step into the REITs and MLP’s (like our previous income trusts) to see the higher yields. I’d also say you’d likely less see much less dividend growth as well.

      Cheers

      Reply to this comment
  3. Death and Taxes

    Apr 02. 2013

    Are MLP like NTI ineligible for TFSA’s? I am still trying to wrap my head around what is considered “arms length” investments on the NYSE. The EPA announced today plans to implement a cap of 10ppm sulphur content down from 30ppm so refinery stocks took a big hit today. I have been watching this one in particular for a few months as a co worker owns shares in it and have contemplated picking up 100 shares if there was a pull back on it.
    Today it dropped from 29/share to a low of 25.09 and then had a small rally settling at 26.38.

    Reply to this comment
  4. Death and Taxes

    Apr 07. 2013

    What are your thoughts about mREITS like AGNC,HTS and CMO?

    Reply to this comment
  5. Steven J Fromm

    Apr 18. 2013

    So basically these are junk bonds in a stock form. You make some really great points as to why these babies have such a high yield and the dangers associated with such stocks. Thanks for the information and insights.

    Reply to this comment

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