What You Need to Know Before Buying a Stock for Yield

Businessman analyzing investment charts at his workplace

If a term deposit or bond was currently paying 5%, rather than a bit over 2%, it probably wouldn’t take much to work out where the market might be trading. Lower would be my guess.

At 4.4%, the current market yield is roughly double what an investor can earn on a term deposit. And that’s even if they tie up their money with a bank for a year, or longer. Despite this massive spread, a record number of managed funds are sitting on an ever growing pool of cash.

With the Federal Reserve in the US now cooling on the number, and timing, of any upcoming rate increases, and the rest of the world’s rates headed in the opposite direction, it’s only going to get tougher for those looking outside the share market to generate an income.

While sitting on such a large level of cash might lower their expected return, the reason for doing it is simple. The fund managers would rather earn less in cash than risk potential losses by being ‘all-in’ in the market.

However, whereas you and I are free to invest when and where we wish, fund managers have much tighter restrictions. For example, they might have to always have a minimum percentage invested in shares, even if they believe them to be expensive.

They might also be restricted by the companies they can invest in. It might be limited to companies in the ASX 200, with weightings similar to the index. So that’s going to mean a lot of bank shares, the supermarkets and Telstra [ASX:TLS].

Despite all being mature and long established businesses, the obvious attraction of these stocks — particularly those in the ASX 20 — is their yield. Telstra trades on a yield of 5.8%, and Westpac [ASX:WBC] at 6.3%, both fully franked. By the time you gross up the yield, that’s way over the market average of 4.4%.

Despite their relatively strong yields, one limitation of investing in these stocks is their tight concentration. Over 40% of the index weight is in financial services, with any hit to this sector putting a hole in a lot of investors’ portfolios.

Given this risk, the temptation is to look for high yielding shares outside of this group. And in this search, the first thing investors often look at is the current yield. That is, the dividends paid out over the last 12 months, divided by the share price, expressed as a percentage.

While that’s a popular place to start, it can be misleading. The problem is that the yield is calculated on the past (the dividend history), while the market prices the shares looking to the future. While historic dividends don’t change, the share price does.

An increase in the share price gives a lower yield, while a falling share price produces a higher yield. That’s why you’ll sometimes see shares with impossibly high yields — sometimes at 15% and higher. What that typically means is that the share price has taken a tumble.

The easiest way to check is to open up a price chart. If the share price has fallen off a cliff, you’ll know straight away that this is why the yield is so high. And that should also give you fair warning. The market is telling you that things aren’t looking all that good for the company. Otherwise, why would everyone be selling?

If you want to look at a current example, then take Slater & Gordon [ASX:SGH]. After its mauling by the market, it’s trading on a yield over 20%. And there are plenty more in the ASX 300 with yields not much below that.

When looking to buy a share for yield, the most important thing to establish is if the dividend looks sustainable. A common measure is to first establish that the cash earnings per share exceed any cash payouts — that is, the dividend. If a company is paying out more than it’s earning, then it’s only a matter of time before something has to give.

The second thing to check is the payout ratio. That is, what percentage of the profits is being distributed to shareholders, and how much of it does the business retain. While it’s easy to get hung up on a particular level, there’s no specific number that fits across the board.

For example, REITs are often able to pass much of their costs on to their tenants, allowing them to payout close to 100% of their cash earnings, while insurance companies might use a range, like Insurance Australia Group’s [ASX:IAG] 60–80%. Such a spread allows them to keep more cash on hand in times of higher claims.

Rather than compare different sectors, a better way to assess payout ratios is by comparing a company’s current payout ratio against previous years. You’ll find this by going to the company’s website and looking at previous years’ results. Often it will show at least five years’ history.

Even if the size of the dividends is increasing, a correspondingly higher increase in the payout ratio should give pause for thought. That too could lead to a cut in the dividend if the payout becomes unsustainable.

Of course, the market can always get it wrong. However, investing in a company with a yield higher than 10% can be a low probability trade. The market is pricing in bad news, or lower profits (perhaps a loss) — all of which will eventually flow through to the share price.

Looking for high yielding stocks outside the mainstream can be one way to diversify your income stream. What you want to avoid, though, is buying into a stock based on a high yield, only for the stock to get hit as investors flee on worries of lower earnings. A fall in price will often do a lot more damage than can be offset by the income generated by the dividend.

That’s a priority with my investment service, Total Income. Finding those top yielding stocks that are not in trouble. That will, in fact, likely see their share prices rise…all while paying out dividends that make the bank yields look trivial. If you want to know how I do that, go here.


Matt Hibbard,
For The Daily Reckoning

Matt Hibbard

Matt Hibbard

Matt Hibbard is Port Phillip Publishing’s income specialist. While most investors focus on making money in the short term, Matt takes a different view. He’s focussed on how you can invest today to grow wealthy in 10 or 15 years’ time. You can find more of Matt’s work over at Total Income where he’s hunting down the next generation of companies that could pay you more each year than you initially invest.

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