Beware the evil temptress of shares with high but unsustainable yield

6th December 2014


Invesco Perpetual’s Income and High Income fund manager Mark Barnett warns of the dangers of stocks with high but unsustainable yield.

Looking for high yield? Has someone told you this might be the answer to your investment needs? One word of warning: beware that evil temptress, known as ‘high but unsustainable yield’.

In the agricultural sector, the words “high yield” have historically had positive connotations, however the same cannot be said for the financial world. Here, there have long been examples of high yields that have proved unsustainable, dating back to the nineteenth century.

Yet investors continue to succumb to the temptation of high but unsustainable yield – they fall headlong into the so-called yield trap, discovering after purchase that the underlying company’s high profits the previous year were not repeatable and that the shares were “cheap” for a reason.

The moral of the story is not to be blinded into investing in a company by the lure of a high dividend yield, without kicking the tyres and carrying out stringent due diligence beforehand.

In a low wage growth, low deposit rate world, dividend income and the scope for that dividend income to grow over time are, for me, extremely important decision-making criteria. The headline dividend yield of a company or starting yield, as it is sometimes known,  is only part of the equation – shares offering a high yield might simply reflect weak short-term price performance, due to a deteriorating profits outlook, rather than because the company’s success has been overlooked by the market.

Thus, I tend to look at a company’s dividend yield in the context of its long-term profits outlook, and relative to its competitors. In short, though it may seem counterintuitive, I would rather invest in shares of a company on a 3% starting yield with excellent growth prospects, than a company on a 6% where I see a high risk of a significant dividend cut.

I am therefore especially vigilant when it comes to interpreting a high yield – is it an attraction or a warning sign? Hence my emphasis on high levels of due diligence, energetic tyre-kicking, hard-nosed rigorous cross examination of expert input followed by healthy internal debate, before I make my initial investment.

Right now, I am heartened by the rising dividend pay-out ratio of the companies in the FTSE All-Share Index as illustrated in Figure 1. What this means is that companies in general, rather than retaining their profits for a rainy day or for capital investment, have been paying out a higher percentage of earnings by way of a dividend.

In light of this trend, it seems probable that total market dividends will grow more closely with the underlying earnings of UK-listed companies in the coming year and consensus for earnings growth for 2014 is about 3.6% (Figure 2). I would therefore expect market dividend growth to be in line with this level. Naturally, there will be some companies which cut dividends and others which grow them by more than the average.

My aim is to invest in companies which can grow their dividend, on a sustainable basis by more than the market average and by more than the rate of inflation.

Figure 1: Payout ratio is back to previous peaks, FTSE All-Share index

il1682_Figure 4

Source: Lazarus Partnership, as at 20 September 2014.

  2014F 2015F 2016F
Earnings per share 3.6 6.7 1.02
Dividend per share 5.9 9.3 8.0
Figure 2: % change table for IBES consensus earnings forecasts, FTSE All-Share index

Source: Thomson Reuters Datastream, as at 7 November 2014. F = Forecast.

While it is true that equities continue to look attractive relative to other asset classes, many valuations still look elevated where, in my view, share prices do not appropriately anticipate the risk to earnings and cash-flows the underlying companies are facing. My investment strategy is therefore, largely unchanged from the recent past. I place significant importance and value on the companies in the market which offer visibility of revenues, profits and cash-flows in this low growth world and which are managed for the sole purpose of delivering shareholder value in the form of a sustainable and growing dividend.

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