Three Pillars and Two Pitfalls of Income Investing
In this chapter we are going to introduce and explain the three key pillars that comprise many of the great dividend strategies – yield, safety and growth. We’ll introduce some important techniques and ratios that can be used to measure each factor and the ways in which they can be combined to achieve a required market-beating return.
According to our statistics at Stockopedia, there were 804 dividend paying companies in the UK market in 2011-2012 with a median yield of 3.1 percent but in terms of £ sterling value, more than 80 percent of total dividend payments were paid by just 15 blue chip FTSE 100 companies. On paper, that might imply that tracking down suitable investment candidates is relatively straightforward. Unfortunately, things are rarely that simple. Dividend policy, or the company’s stated intentions when it comes to shareholder payouts, is heavily influenced by management decision-making. That means there are psychological factors at play – from the decision to initiate a dividend and make annual increases through to cutting or even suspending payouts. Bearing in mind that even the biggest blue chips with the proudest dividend records can (and do) suffer catastrophes, then the job of the investor is complex. It’s a delicate balance as we shall see.
Dividend Yield - Crown Jewel or Emperor’s New Clothes
“Do you know the only thing in life that gives me pleasure? It’s to see my dividends come in” John D Rockefeller
We all share the fantasy that we might stumble upon an unloved, misunderstood or otherwise incorrectly priced gem that’s just throwing off cash. In a low return world, who wouldn’t want to own a stock with a dividend yield of 10 or 12 percent? But while the dividend yield may be highly promoted in the financial press it can’t be taken at face value. Its interpretation requires nuance without which the ‘chase for yield’ can lead to an exceptional amount of pain.
In simple terms, the yield measures how much a company has paid (or will pay) in dividends relative to its share price. It is a crucial metric for investors because, in the absence of any share price gains, the yield is the only return on investment for a stock. It also allows investors to compare the relative income streams available between stocks and bonds.
But whereas the interest on a bond is fairly certain to be paid, there is no such guarantee with dividends. While company management are always reluctant to cut the prevailing level of dividends, at times of crisis companies have to preserve cash. That makes the choice between defaulting on debt payments or cutting dividends an easy one.
The typical yield cycle
Successful listed companies generally travel through a cycle from fledgling growth outfit to mature stalwart over many years and during that time their dividend policies change substantially. In the early growth period, dividends are rarely paid because stakeholders often prefer to see profits reinvested back into the business. When cashflow starts being generated sustainably and reinvestment needs lessen, dividend payments are initiated at a very low level (generally at a 0.5 percent to 1 percent yield). From here, they can then consistently rise while still allowing enough cash to remain in the business to fuel growth. Typically, the yield will then grow more quickly than earnings until the company reaches maturity, at which point the yield reaches a sustained level of 4 percent or more and the majority of profits are returned to shareholders each year.
Of course many companies run into trouble or go ‘ex-growth’ before they ever get to that stalwart stage - sometimes due to no fault of their own - and whenever investors smell trouble they sell the stock, driving up the dividend yield in the process. As a result, the types of companies that offer higher yields can be a mixture of both steady payers as well as those that are unpopular, at business cycle lows or in states of distress.
As we saw in Part 1, the evidence suggests that this diverse group of high yield stocks does generate anomalously high returns. One of the studies in the previously mentioned Tweedy Browne paper looked specifically at the UK market over 35 years up until 1988 and found that the highest yielding decile of stocks outperformed the lowest yielding by almost 6 percent annually. In order to build confidence in an investment strategy that seeks to harvest this ‘yield premium’ systematically, it’s worth understanding why the anomaly may persist and why there aren’t more investors chasing the returns on offer.
Why do high yield stocks provide higher returns?
Dividend yield investors are a curious lot - they usually prize certainty of income over everything else. Pension funds especially are under pressure to pay out a constant stream of income and need their investments to bear expected fruit in order to match their liabilities. So whenever a stock looks to be having trouble and at risk of suffering from a dividend cut, a large group of shareholders will start to ask questions… “where will the yield end up?”, “will these problems continue?” and more importantly “how will we meet our income liabilities if the dividend is cut?”…
As a result many investors over-react to bad news in dividend stocks, feeling obliged to just dump their shares regardless of price in order to reinvest in safer, more certain waters. These worries often drive prices down too low for the risk, providing an opportunity for canny contrarians.
If you do invest in these stocks you could be the beneficiary of two bangs for your buck. Even if a dividend cut does occur, you may still end up getting a half-decent yield after all, but more importantly you could end up with a nice capital return to boot as the uncertainty surrounding the stock dissipates. But as is so often the case in these situations, it takes the mentality of the value investor to venture forth and pick up the returns left on the table.
Income investors aren’t all stupid - the trouble with high yield
While the group of income investors throwing away the very highest yielding stocks are leaving some return on the table for contrarian vultures to pick up on, they do realise that the risks associated with these stocks may not be worth the hassle. High risk, high yield dividend strategies come with a generally unpalatable array of nasties that most investors don’t have the thickness of skin to cope with - perhaps that’s what high yield investors get paid for dealing with. Let’s investigate four common high yield hazards worth being aware of.
Hazard 1: The very highest yielders can be more volatile
Whenever the market is expecting and pricing-in future problems for a company, the price can see-saw as the apparent size of the dividend becomes detached from the true expectations around the stock - analysts may be slow to downgrade their dividend forecasts while the previous dividend may be unrealistic to achieve again this year.
Let’s say that a stock’s annual dividend per share is £1 while the stock price is £10 per share to yield 10 percent. If the price of the stock plummets to £5 per share because of, say, cashflow problems, the new yield percentage is 20 percent (£1 dividend / £5 price). When screening the market for stocks this might look really juicy to you because it looks like the yield is increasing. The problem with this logic is that it actually rewards a stock for tumbling in price…
In this confusion over expectations, the highest yielding decile of stocks can have a tendency to become vastly more volatile as new buyers are lured in by the headline yield and recovery possibilities, while sellers become willing to throw it away at any price. Many shareholders just can’t stomach that kind of the volatility in their portfolios.
Be prepared to weather high volatility if investing in the highest yielding stocks.
Hazard 2: High yields bring higher risk of dividend cuts
Back in September 2008 Lloyds Banking Group was boasting a head-turning yield of around 8 percent. Investment commentators were amusing themselves over the fact that the banking giant’s shares offered a stronger return than a Lloyds TSB internet saver account. However, the banking collapse that followed shortly afterwards put Lloyds’ dividend loving shareholders to the sword. Stocks may be priced as bargains for a reason - the market thinks the company is in trouble and is worried that the dividend can’t be sustained or will be cut, as a result high yield stocks come with a price-tag of increased risk and share price volatility.
Often, in the highest yielding segment of the market at least half the stocks will be paying more in dividends than they make in profits, if they make profits at all. Intuitively one would expect these stocks to be the most susceptible to dividend cuts, and the evidence does seem to back this up.
A Credit Suisse study of S&P 500 stocks from 1980 through to July 2006 found that the 2nd and 3rd highest yielding deciles outperformed the top yielding decile significantly. Similarly, Bank of America-Merrill Lynch divided Russell 1000 constituents into quintiles from 1984 to 2010, again finding that the second highest yielding quintile provided the highest risk-adjusted returns. In other words the highest yielding stocks in the market actually don’t pay out what you expect them to! They are the ultimate temptress.
Avoid picking stocks from the highest yielding decile in the market. Pick from the second, third or even fourth highest decile preferentially.
Hazard 3: High yield strategies create sector over-exposure
Companies within sectors have different policies when deciding how much cash to pay out in the form of dividends. As legal monopolies, utilities by their nature tend to have reliable revenue and high dividends, whereas technology and energy companies generally need to reinvest their earnings. Focusing purely on building a portfolio with high yield stocks could lead you to concentrate too narrowly on one sector.
In a similar way, the best dividend payers in the market tend to be a handful of FTSE 100 companies. Focusing your portfolio on just the high-yielders creates stock or sector-specific concentration risks that can leave portfolios overexposed - as illustrated by the millions of investors whose income was slashed when dividends were cut in the banking crisis of 2008.
Some investors are happy to accept these kinds of risk – one such example is Neil Woodford (previously at Invesco) who has been firmly over-weight in the large-cap pharmaceuticals sector for some time in order to pick up the attractive yields there. However, this is a risk that should be consciously undertaken based on a macro sector view, rather than just assumed by accident.
Beware of becoming overexposed to specific sectors in high yield strategies.
Hazard 4: High yield strategy returns can be inconsistent
There are contrarian voices heard against pure yield strategies, most notably in the very decorated academic Ken French. He discovered that high yield stocks have very variable returns depending on the decade chosen. In some decades, notably the 1970s and 1990s, the highest yielding stocks actually underperformed the lowest yielding stocks. It appears that during inflationary periods or periods of rising interest rates high yield stocks can behave much more like bonds and lose value. As we saw in the previous chapter, the best conditions for investing in higher dividend paying stocks are during sideways markets as bull markets tend to favour speculative growth stories. Don’t get caught pushing on a string!
Ensure that market conditions favour strong dividend returns before venturing into high yield strategies.
Share Buybacks - the dividend yield’s blind spot?
For many years, companies have been increasingly spending their excess cash on buying back their own shares in the open market rather than just paying it out as cash dividends. These ‘buybacks’ have increased massively in popularity since the early 1990s: between 2000 and 2012 Next Plc returned over £2.6 billion to shareholders by way of share buybacks compared to only paying £1.2 billion in dividends.
As a result the reported yields for many shares have fallen. As both dividends and buybacks are designed to return cash to shareholders it ought to be vital to factor buybacks into an overall dividend yield analysis - yet so many investors fail to do it.
Introducing the Net Payout Yield
One way to take advantage of this blind spot is to calculate the so called ‘Net Payout Yield’. This is defined as the level of dividends plus buybacks minus any share issuance divided by the company’s market cap. A 2004 paper by US researchers Boudoukh, Michaely, Richardson and Roberts found that the net payout yield was a “superior predictor of equity returns than simply using the dividend yield”. This has been confirmed in the book, Your Next Great Stock, where Jack Hough showed that between mid-1983 and the end of 2005 using the Net Payout Yield would improve the returns of a high yield strategy by almost 3 percent per year. Clearly, when searching for high yield stocks, not factoring in buybacks by using the Net Payout Yield may mean that you miss out on some excellent opportunities.
Reasons for caution
While clearly the net payout yield is more comprehensive than the bare vanilla yield in some regards, there are reasons to remain sceptical that it should be given equal status in dividend strategies:
Firstly, some high net payout yield companies may not pay out a dividend at all, which could be a trap for those seeking high income.
Secondly, buybacks may be initiated by management for the wrong reasons. Many management teams are encouraged to increase earnings per share as part of their incentive plans. Initiating a buyback campaign reduces the number of shares in issue, thus increasing EPS and therefore also their bonuses!
Thirdly, buybacks are often mistimed. In 2012, Thomson Reuters examined returns on stocks in the S&P 500 in the periods following buybacks and found that the majority of companies un- der analysis had typically timed their buyback activity poorly. As Warren Buffet has noted, “many CEOs never stop believing their stock is cheap”.
Finally, net payout yields are usually more volatile than dividend yields. As opposed to dividends, which generally require a long-term commitment to distributing surplus profits, buybacks can be made with a lot more flexibility and then carried out (or suspended) as the managers sees fit.
Look before you leap!
Despite yield playing such a central role in dividend investing, it’s important to realise that, by focusing on yield alone, you may be exposed to the vagaries of the market – not to mention the occasional disasters that may befall companies and sectors. Dividend yields which look too good to be true usually are. Reaching beyond a yield of 8 or 9 percent is not going to pay any further dividends. It’s actually more likely that you’ll receive less. As we’ll see in the next chapter the dividend yield needs to be interpreted in light of the rest of the company’s financials to determine its safety and sustainability.