Dividends: Are high yielding companies safe?

16th January 2012

There are many schools of thought when it comes to income investing but, within them, there are some elements of conventional wisdom that income-seekers would do well to challenge – the first of which is that large, high-yielding companies are safe.

You might immediately point to BP as a glaring example of a large company that suspended its dividend although really that illustrates precisely the opposite point – were it not for the strength of BP's balance sheet and its conservative approach to debt and financing, it would in all likelihood have gone bust after taking such an enormous hit.

Of course, BP did not go bust and has now reinstated its dividend. However there are a number of other businesses among the UK's largest companies that appear cheap but have huge amounts of debt. Debt is actually rather perverse because it can help boost a company's fortunes when times are good but, if something goes wrong – no matter how unlikely that event – it will only magnify the problem and may wipe a company out. With debt there is no margin of safety.

Another idea that needs challenging is that a high yield guarantees an attractive income. This is an issue because, as income investors, we are all looking for a reasonably attractive yield but there is a trade-off here, which involves avoiding companies that offer an attractive dividend yield but, for whatever reason, have no potential to grow that.

What income investors really need to identify is an attractive free cashflow yield as that is what pays the dividend.

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