When to be Wary of High Yielding Stocks

Just because a stock is offering an attractive income does not mean it is a savvy investment. We outline when you should be wary of high income-paying companies

Emma Wall 16 February, 2015 | 11:03AM
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Emma Wall: Hello and welcome to the Morningstar series, 'Why Should I Invest with you?' I'm Emma Wall and here with me today is Hugh Yarrow, Manager of the Evenlode Income Fund.

Hello Hugh.

Hugh Yarrow: Hi Emma.

Wall: So, we're here today to talk about yield. It's been talked about before, but unfortunately we continue to be in a low inflation, low interest rate environment and people really need income. The problem with this is they see a headline rate and they pile into what could be an unsuitable stock. I mean, what do you think about that?

Yarrow: You need to be careful investing in stocks that pay dividends. Something that we focus on is free cash flow. So, we think about the revenues that the business generates, we take away the expenses, the interest and tax and then we are really interested out of what is left over how much needs to go back in the business to keep growing and we like businesses that can keep growing sustainably without needing to channel much capital back in.

That means that you do have spare cash flow which can not only pay this year's dividend but can also create a nice growing stream of dividends into the future.

I think that is something that you do need to be careful with particularly at the moment when there is a lot of pressure on corporate cash flows; the economic environment is tough; as you say, inflation is low; there is a lot of deflation in the world and businesses that have very high capital expenditure requirements that eats into cash flow and what you have to be careful of is a business isn't paying its dividends out of debt rather than out of cash flow.

Wall: Because there are a number of different reasons why a company can be displaying a high yield. It could just be that the share prices crashed such as with the miners and then this dividend perhaps – this yield may not be sustainable if the share price comes up. How do you protect against that?

Yarrow: We like businesses which we think are quite resilient in terms of if there is a downturn in the economic environment but also if there is a downturn in the industry or a specific problem with the company. So, repeat purchase items, things like soap and shampoo that people keep buying even in more difficult times, but also businesses where there's quite a high degree of recurring revenue that might be subscription-based revenue that has a high renewal rate, things like that which give you confidence that the cash flows can continue into the future.

But you are right, a stock can be paying a very high dividend. It looks attractive today, but if the environment changes, the cash flow drops and suddenly that business isn't able to pay those dividend payments.

Wall: You mentioned there, be careful that dividends aren't being paid out of debt, but of course, you have got some very high profile companies such as Google who are raising money through bonds to then pay dividends. I mean, is it always as black and white as making sure that the dividend is covered, is paid out of cash?

Yarrow: Certainly, we look at the long-term profile of cash flows, historically and what we think will happen in the future and we certainly will only invest in businesses where we think free cash flow over the long term will cover the dividend today and the growth in dividends. Debt is very easy for companies to get at the moment.

I mean, Nestlé's yield went negative last week. So, we are in unprecedented territory. But at some point the environment will change and debt won't be as cheap again. Businesses that have been funding their dividends through debt will obviously find that very difficult.

Wall: What about some sectors perhaps that we should be wary of then? Are there any danger yield sectors at the moment?

Yarrow: Well, I guess the oil majors are an obvious sector at the moment given the very steep fall in the oil price and their businesses that are very capital intensive and have a lot of investment requirement. So, a lot of their cash flow needs to go into buying oil for the future. Now, I'm not saying that these companies will cut their dividends.

They will do everything they possibly can to maintain them.

But then the problem is they have to cut their capital expenditure and what that risks is, underinvesting in the long-term future of the business and the long-term potential for cash flow growth and therefore, dividend growth. So, that's something to think about. These businesses might be able to maintain their payments at the current level, but the likeliness of growth rates that are decent in the future is not so good.

Wall: What about some areas perhaps that you are more positive on then?

Yarrow: There are four key sectors that we are currently invested in all of which are asset-light cash-generative businesses that are quite resilient in terms of the overall economic environment, healthcare, consumer-branded goods companies, software companies with nice recurring subscription revenue and business-to-business media companies as well and those four sectors make up about three quarters of our fund and we think the potential for dividend growth in those companies looks good.

Wall: Hugh, thank you very much.

Yarrow: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar

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