A member of Canadian Money Forum started a thread about a particular stock with an extremely high yield (19%). In particular, the member was wondering if the stock was a good buy at that yield. I can see how buying something with a 15%+ dividend/distribution would seem attractive initially, I mean, who needs to index their portfolio if they can get 15% return without even counting for capital appreciation? However, there are pitfalls in chasing high yield and it can be a short sighted investing strategy.
The Problem with Chasing Yield
What is the problem with super high yields? The issue is that sky high yields can result in payout ratios that are at unsustainable levels. The payout ratio is the percentage of company earnings that is used for the dividend/distribution – in some cases, the company pays out more in distributions than earnings which is a red flag in my books. The higher the payout ratio, the higher the likelihood that the distribution will be cut. Not only does this mean that the distribution will be lower for the investor going forward, in most cases, the stock price/market capitalization of the company drops as well.
For example, Superior Plus (SPB.TO) up until recently was paying a dividend of 13% or $1.62 per share with an unsustainable payout ratio. In their latest announcement, due to weaker earnings, they decided to slash the dividend to $1.20 per share. The result? An 8% sell off the very next day.
Looking for other examples of high yield stocks? Just use a stock screener and use dividend yield as one of the criteria. Note that some income trusts and REITs are able to pay out more than their earnings as some of them distribute Return of Capital.
Another Way to Buy Yield
It may sound like I’m contradicting myself, but in my article on “when to buy dividend stocks“, I explain that I wait until the stocks that I’m watching reach a certain yield. How is this different? In my dividend watch list, I follow companies that have a history of increasing their dividends over time. How do they do this? By consistently growing their earnings, and maintaining a sustainable payout ratio. Sometimes, these stocks are irrationally sold off (sometimes not), but when they do reach an attractive yield, it’s my cue to do more research and perhaps deploy more cash into the company.
For those interested in dividend stocks, and would like to maximize yield, there are three points of due diligence to begin with. That is, the dividend history, earnings track record and the payout ratio. If you come across a stock with a yield that is too good to be true – it likely is.
Are you a dividend investor? If so, what kind of due diligence do you perform prior to taking a position?