First things first, we’re putting the final touches on a Dividend Bull List stock. We’ve narrowed it down to a select few companies and will be making a decision sometime this week.
In this e-mail, we’ll go over an income investing strategy that investors tend to get away with in a bull market but can turn nasty relatively quickly in a bear market.
We know that income options are now becoming more popular among Premium members. This makes sense for a few reasons.
We have expressed that members should now be looking for cash flow-positive companies that can weather an economic downturn. This doesn’t necessarily mean they have to pay a dividend. We have plenty of cash flow-positive companies on the growth Bull List. The only option that isn’t right now is Lightspeed.
But for the most part, companies that have been consistently profitable for long periods tend to pay out earnings as a dividend. Stable earnings, along with the fact investors are still collecting a dividend during an economic downturn, give dividend stocks two distinct advantages.
For one, their stock prices hold up better. Why? Because investors collect a dividend. An individual investor is much more likely to hold on to an income-paying stock during a drawdown rather than a pure-growth option, as there is theoretically nothing to gain in the short term by holding that growth option. Yes, this is a short-term mentality and one we don’t advocate for. But, we can’t ignore the fact it exists.
When push comes to shove, and someone is deciding between two holdings, it’s not hard to say, “this one is paying me a dividend every quarter, so I’m going to keep it.”
Secondly, this one is blatantly obvious, but it’s the fact you collect the dividend while the markets are in the tank. A passive income stream during times like this can allow investors to re-invest those dividends into lower stock prices, allowing for more significant compounding returns in the future.
However, with bear markets comes lower earnings, falling stock prices, and yield traps
As stock prices fall, yield rises. In a bull market or a period of rising earnings, investors tend to get away with chasing high-yielding companies. But, if we were to enter a multi-year recession, chasing high-yielding stocks would become an especially risky endeavour.
Don’t get us wrong, not all high-yielding companies are bad. However, as mentioned, the yield rises as the stock price falls. And if a yield becomes unnaturally high, it may be due to a fundamental shift in the underlying company, and we could be at risk of a dividend cut.
In this e-mail, we will go over how to avoid chasing yield and make wiser and ultimately better investment decisions.
The allure of a high yield can be pretty tempting
However, chasing yield can often result in mistakes. First, let’s clarify the concept of chasing yield – which is to buy stocks with the main investment thesis being a high dividend yield.
Many investors are blinded by high yields and completely ignore the potential pitfalls of investing in high-yielding stocks. For the purpose of this conversation, we’ll define high yield as stocks that yield 6% or more.
Unfortunately, when a high yielder fails to perform and ends up cutting the dividend, the end result is usually a selloff and no one wants to get caught in that scenario. Not only will yield chasers generate less dividend income but their investment will decrease in value as well, often permanently.
Let’s be clear – as mentioned, not all high-yielding stocks are bad investments. On the contrary, there are many excellent companies that offer a sustainable high yield.
Pipelines, telecoms, utilities, and real estate investment trusts (REITs) are all good examples of industries that typically offer higher (and sustainable) yields.
The issue is in the individual investor’s research stopping at yield
Yield chasers often ignore warning signs, or worse yet, will not conduct further due diligence beyond the yield of a stock. They see a stock, maybe recognize the company name, and will buy it because of its yield.
We’ve witnessed this fairly often, even among Premium members reaching out to us. They’ll buy one of the weakest companies in a sector because of its high yield. This is a mistake.
The company’s yield could be high because of chronic underperformance. And as you know by now, when a stock price falls due to this underperformance, yield rises.
Let’s use some historical examples of chasing yield.
Vermillion Energy
Vermillion Energy (VET) is a well known energy stock. In early 2020, the company’s share price was under pressure and the yield jumped to the 9% level.
We had several members ask us about the sustainability of the dividend. We weren’t surprised by this, at all. It is not uncommon for us to start receiving inquiries on stocks once their yields get unsustainably high. The allure of buying something and passively earning 9% a year is tempting. We’re just glad they asked the question first because it wasn’t a pretty situation for investors of Vermillion.
Upon further research, the company’s dividend didn’t look entirely safe due to the dividend accounting for a higher percentage of cash flows year over year. As you can see below, the company’s cash payout ratio was dangerously high leading into the pandemic, often making up over 125% of cash flow. A dividend cut was obvious long before then, as payout ratios exceeded 125% of cash flows for years.
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In Vermillion’s case, many who advocated for the company pointed to comments from the CEO which re-iterated that the dividend was safe. Then, the pandemic hit and the price of oil crashed. Vermillion slashed the dividend by 50% before suspending it entirely. Those who chased that 9% yield ended up being extremely disappointed.
As you can see below, post-dividend cut some investors were sitting on losses in excess of 90%. What good is a 9% yield (which investors lost after the cut anyways) when you’re underlying investment nearly vanishes.
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The dividend was not reinstated until a year later and even today, it is only a third of what it was 3 years ago. Why? Because even before Covid-19, the yield was not sustainable. The pandemic actually gave them an out to reset expectations.
Another good example, and a once popular Canadian Dividend Aristocrat, was Corus Entertainment (CJR.B)
Before the company’s Shaw acquisition, it had built up a dividend growth streak and had a solid yield in the 4% range.
Then, the company overextended itself and the yield jumped to 9-10% range before peaking at 30%!
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Bulls pointed to the fact it was an Aristocrat and that the dividend was well supported by cash flows. Which was true to an extent. However, in no circumstance is a yield that high a good business practice. In fact, no corporation can pay out a 10%+ yield and deem it fiscally responsible.
The end result? Corus slashed its dividend by ~80%. The company’s share price has followed and it has never really recovered. As you can see below, those who bought the company when its yield became this high are sitting on losses in excess of 80%.
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Since this company was a Canadian Dividend Aristocrat with seemingly solid coverage ratios, investors were blinded by this yield trap. However, a quick look at a lack of revenue growth and sporadic earnings would have told an investor all they needed to know.
There are many more situations like this. But these two should paint a picture of how devastating chasing yield can be.
A few lessons to learn here
Lesson 1: Don’t make decisions solely on the ‘word’ of a CEO or company management. If a CEO says the dividend is safe, it does not mean it is. There are many examples of CEOs, Board Chairs, or other senior leaders coming out in support of the dividend, only to have it cut only a few short months later.
In fact, it has even happened here at Premium. RioCan, a previous Foundational Stock before the pandemic, came out and stated the distribution was safe. Shortly after, it was slashed. Always trust the numbers. Ignore the noise, which includes comments from the company itself.
Lesson 2: Just because a company has a long history of dividend growth, it does not mean the dividend is safe. There are numerous examples of former Canadian Dividend Aristocrats who lost their dividend growth streaks because of a cut to the dividend. Many of these cuts were a direct result of underlying issues with fundamentals which led to a decrease in share price and subsequent increase in yield. Those who failed to research the underlying company and instead bought on the sole basis of a high yield got burnt.
As the saying goes, “past performance is no guarantee of future results.”
Lesson 3: Many think all utilities, pipelines, telecoms, and REITs that have high yields are safe. This is a dangerous direction.
Even in these industries, an investor must still do additional due diligence. It is not uncommon for companies in this industry to slash their dividend. As mentioned, RioCan (REI.UN), one of the largest REITs in the country cut its distribution last year as it was no longer good business practice given our new, post-pandemic reality.
We can’t stress this enough. If there is a company that has a high yield, ask yourself (or us), why?
Did the company have a recent dip in share price? If yes, why? Bad earnings? Disappointing outlook? A change in strategy?
Maybe the company’s yield has always been high. Does this mean the dividend is safe? No.
Perhaps the company is suffering from negative growth. In turn, this causes the dividend to eat up a greater percentage of cash flows or earnings and payout ratios are trending upwards. This is likely not sustainable over the long-term and if there isn’t a return to growth, that dividend will likely become more at risk.
This is often where yield traps are created, as experienced investors will sell off these stocks as soon as they see the warning signs. Look no further than the chart earlier in this e-mail for Vermillion. In turn, this pushes yields up and exposes investors trying to take shortcuts with their research to jump into a yield trap.
Bottom line is this – there are many factors that influence a company’s dividend yield. The mistake yield chasers make is not understanding these factors. Only after an investor has done their due diligence should they feel comfortable investing in high-yield stocks.
Always drown out the noise and let the numbers do the talking.
