For anyone who has followed our team’s investment philosophy for a considerable amount of time, it’s exceedingly likely that you have heard us extoll the virtues of investing in dividend paying companies, and more specifically dividend growth stocks.
Our passion for this topic notwithstanding, it is possible to have too much of a good thing. In my opinion, one of the most dangerous 5 letter words in the investment world is yield, and particularly how the search for yield can lead investors astray in constructing a portfolio.
To level-set, yield in the investment business is defined as the annual cash flow an investment produces divided by the price of the investment. For example, a company trading at $10 a share, which pays $1 a share in dividends has a dividend yield of 10%.
Once you begin to view investments through the lens of yield it’s natural to want more. For example, it’s extremely common for someone looking at dividend stocks to begin by looking at those paying the highest yields. Isn’t more yield always better?
In my opinion, and the consensus of our team’s investment committee, some of the riskiest investments are those that pay the highest yields. In this quarter’s dividend letter, we’re going to unpack the most common reasons why high dividend yields exist, why they may be riskier than they appear, and how our strategies attempt to mitigate these risks while still generating attractive dividend yield relative to the overall equity markets.
What kind of companies pay the highest dividend yields?
As we touched on in the introduction, an investment’s yield is a function of both its dividend payment and its price. As a result, high yield investments can be those with high growth in dividend or a sharp drop in price. Oftentimes, investments with high yields are those with the highest risks of reducing their dividend; where the stock price has adjusted to concerns that are not yet showing in the dividend.
Next, there are multiple types of companies that by law are required to distribute a significant amount of their earnings. By their tax structure, MLP’s (commonly energy pipeline companies), REIT’s (Real Estate Investment Trusts), and BDC’s (Business Development Companies), are legally required to distribute a significant amount of their income. In some cases, these companies are paying high dividends at the same time they are selling new shares to raise capital, so in effect if you spend your dividend, you’re actually owning a diluted ownership stake every year.
Encapsulating this list, a view of the highest dividend yielding stocks in the S&P 500 as of 10/22/2024 includes the following (US News): one REIT that already cut their dividend, a carmaker with a history of dividend cuts, a drug maker with a challenging pipeline & patent cliff, an asset manager with persistent outflows, a tobacco company poorly positioned for the shift to smokeless products, and a drug store chain whose dividend has been cut but the stock price has fallen faster thereby actually increasing its yield.
In any one period of time, these under-performing companies can in fact see massive price rallies, particularly when the economy improves, but as a sustainable investment strategy in my experience those that chase yield instead face decreased distributions, lower values, and a frustrating overall strategy.
So how can you create income in a portfolio?
Don’t let the negative tone in the preceding paragraphs mislead you. There are absolutely ways to create dividend income that in our opinion is sustainable and can be relied on. Within our investment committee we rely on the following guardrails when searching for yield in client portfolios:
Is the company growing, or at least holding its ground relative to inflation?
Companies with businesses that are “melting ice cubes” generally make poor stock investments. We look for companies that are ideally improving in business quality, or at minimum, maintaining their competitive position.
Don’t ask for too much
A quick google search (or ChatGPT if that’s your thing) will tell you that the current S&P 500 dividend yield as of 6/30/2024 is 1.32% (YCharts). As a result, when we construct strategies, we’re generally looking at our universe as a percentage of the S&P 500 yield. For our higher yielding selections, we’ll look for a strategy that overall targets 2-3X the index yield. 2.6-3.9% is a far cry from the high single digits – low double-digit yields that some investment newsletters may pontificate about, but being reasonable about how much yield your portfolio can generate will position you much more favorably to have an income stream that can grow rather than one that is destined to fall as companies falter.
Read the Financial Statements
While by no means an exciting endeavor, analyzing the financial statements of the companies that we invest in on our clients behalf is vital to our process. My favorite metric to evaluate the “sustainable dividend” of a business is to calculate the following:
- Business Net Income
- + Depreciation & Amortization
- + Net Change in Working Capital
- – Maintenance Capital Expenditure
Stripping away the accounting jargon of these calculations, this metric gives us a clear view into the true amount of cash the business generates after accounting for the required expenditures needed to keep the business running at its current level. If a company is paying over 100% or even close to 100% of this cash flow out in dividends, its relatively unlikely the business will have the ability to grow and may be at high risk of cutting their dividend should the business hit a speed bump.
Much like Jeremy Wade enjoyed the thrill of fishing in risky waters on his hit series River Monsters (if you haven’t seen it, look up a Goliath Tiger Fish!), we take great pride and duty in our role of researching and implementing investment strategies on behalf of our clients.
On behalf of myself and our team’s 6-member Investment Committee, thank you for your trust. It has been a strong year for the markets, but we are ever focused on navigating the waters on the horizon, and it is to that end that we work.
November 2024
