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Yield Chasing as an Investment Strategy?





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.

Final Thoughts

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?





16 Comments, Comment or Ping

  1. 1. cannon_fodder

    I seem to remember a certain blogger had a Smith Manoeuvre portfolio with Teck Resources in it. And that Teck was trading in the low teens with a double digit yield.

    I ended up buying it for my own SM portfolio. The yield was too tempting.

    Sure enough Teck suspended the dividend not long after I bought it. Teck kept falling going to a multi-year low and close to 60% below my ACB.

    (fortunately I held onto it and it’s now 5x my original ACB and has reinstituted a dividend yield that is more realistic.)

  2. lol @ canon_fodder – We all make mistakes! In that case, I made the mistake of holding it until the bottom. The second mistake of not buying back in! :)

  3. I find that super high yields usually mean something is wrong and that the company likely cannot sustain said yields. They are almost a warning flag ….

  4. I’m not a big fan of super-high yields. Just like Sustainable PF said, something is wrong; you can’t pay out more than you earn, unless you’re like 90% of Canadians who keep credit card debt :)

    @Frugal Trader – any stocks in your portfolio you’re concerned about, higher-than-liking yield? I would assume no since most of your portfolio are big blue-chips and Canadian financials correct?

  5. 5. Echo

    Someone asked me a few weeks ago about investing in Superior Plus. I’m glad I told them to wait until they announced 4th quarter earnings this week.

    All things being relatively equal after I look at P/E, current yield vs. avg 5 year yield, and dividend growth rate, I’ll look at the payout ratios to decide between companies in similar industries. That’s one of the reasons why I chose EMA over TA, which has worked out nicely so far.

  6. 6. Former Yield Chaser

    I’ve been bitten a few times by high yields as well. Bank of America had like an 8% yield before they almost went bankrupt due to the credit crisis. I also had Yellow Pages Income Fund that was paying like 15%. Another one was Harvest Energy Trust, that one was like a 20% yield at some point… all have lost money for me. Yield chasing can definitely be a money losing strategy

  7. 7. Rachelle

    I also asked myself this question a few years back… and I created a virtual portfolio of high yielding dividend stocks. In Oct 22, 2009 I “bought” one hundred dollars worth of the following high yielding stocks.

    SXP-T
    SRV.UN-T
    PZA-UN-T
    MMN-UN-T
    GPA-PR-A-T
    GII-UN-T
    ECI-T
    CWX-T
    BPT-UN-T
    AI-UN-T

    There was no strategy I did a stock screen and picked the highest earners. The return of this portfolio over time is 19.4% Three stocks have been delisted. The market value is 1054$ and I bought $1000 worth ($100 each)
    At times this portfolio looked like a dog’s breakfast but if you look at the results over time, it could be worse.

    My advice for someone trying this strategy would be not to put all your eggs in one basket. Some of these stocks are just chugging along paying out their dividends years later, some have reduced their dividends. I don’t know what happened to the ones that were delisted, I have to admit I had consigned this portfolio as a bad idea and stopped looking at it until this morning. The proof is in the pudding.

    Yield Chasing is a viable strategy and seems to work according to my limited research on the subject.

  8. @Rachelle, it would be an interesting experiment to see how this strategy would work under bull and bear markets. From 2009 to now, everything has gone up. So is that a 19.4% return since Oct 2009 including dividends? So a total return of $194 after all dividends?

  9. As you say there’s got to be a story behind it. If the company’s been paying a 19% yield for 5 years in a row the earnings might be sustainable but that’s generally not the case, so the high yield may have come from a recent drop in the stock price. You need to look at what news instigated that, and see if other things have been affected (are the earnings and balance sheet consistent with what they have been in past years or did they take a big hit? Are there signs that they are unsustainable?)

    Markets are very efficient and pricing in emotions and stocks can get pushed around by uninformed individual investors (though at other times the influence does come from managers with better research) so if you understand the reason why the yield is so high but disagree with it, it might be a good buy.

    The biggest challenge to this type of approach is that there are enough would-be value investors and yield chasers that as soon as a stock’s yield starts getting high enough it’s likely to get more demand just because of that. I have no idea if this is strong enough to neutralize an overreaction to bad news or even drive the price higher; it could go either way depending on the situation but it’s likely to be a factor in anything you look at so you have to be careful with your analysis.

  10. 10. Rachelle

    Yes, plus the three that were delisted were bought out by other companies it seems, the final trading price was not $0 but rather -10 on the $300. The money was not reinvested in more high yielding stocks which is something that would have happened in a real portfolio which would have increased or decreased yields.

    I also want to point out that the $ value of these stocks was pretty low. The highest purchase price was $11.00.

    Of course I have no idea what would happen in a bear market. It was a bit of a thought experiment with counter intuitive results. My thoughts on the bear market are that these stocks are already punished and you might not see the sell off that you might expect.

    I also did not see any super-fantastic returns or rebounds in this portfolio, something that is possible when buying a stock that is beat up. The best return is MMN-UN-T 50.2%

  11. 11. Rachelle

    OK, thats weird my portfolio is giving me a return of $241.15 or 19.4% and I’m not sure how the math is working because obviously $241.15 gives me a return of 24.115% on $1000.00

    Also dividends were not reinvested.

  12. 12. Rachelle

    I also want to point out that a similar portfolio which contains stocks I “liked” and wanted to watch has an overall return of 13.1% I bought these at various times and there are way too many to list. This just goes to show that I should not pick stocks I like :).

  13. Wish I had chased more yield back in early 2009 when bank dividends paid more than 10%!!

  14. 14. Balk

    I am curious to see if anyone has AGNC and NLY in their portfolios. What are your thoughts on these two? NLY seems to be chugging along with high yields for quite some time.

    Cheers,

    Balk

  15. 15. Joe Sn.

    To compare Rachelle’s strategy to the market performance:

    The highest close of the TSX in Oct 2009 was 11504.
    The TSX closed today at 14123, or a total increase of 22.7%.
    Note if I used the low close of the TSX in Oct of 10910, the return would be 29.4%.

    In my opinion, anyone picking random stocks (including monkeys throwing darts) from the TSX in that time frame could easily have a return in the range of 20% to 30%.

  16. 16. Andrew F

    Another thing to think about is not just considering dividend yield. Dividends are just one channel to return profits to shareholders. The other method is share buybacks. You need to consider both when look at the payout to shareholders.

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