Dividend investing is generally assumed to be a safe and stable strategy. But this term, of course, can actually include a wide range of approaches that cover various levels of risk.
Investing in high-yield dividend stocks, for example, is a strategy that has the potential to deliver huge returns or substantial losses. While each high-yield stock is unique, the outcome generally hinges on the answer to one question about the source of the high yield.
Breaking Down Dividend Yield
When considering a stock’s dividend yield, it is important to keep in mind that this figure is the quotient of a backward-looking metric (dividends paid) and a forward-looking metric (market cap). Because of this mismatch, achieving superior returns isn’t nearly as simple as snapping up any stock with a yield above a certain threshold.
The share price reflects expectations about future dividends and profitability, while the numerator considers only historical dividends paid. When a company has experienced a significant disruption in its business, the historical dividend record may be meaningless as a future indicator (as an example below will illustrate). Then again, high-yield stocks sometimes appear because the stock price has been temporarily depressed for irrational reasons.
The Key Question
When considering a high-yield dividend stock, the question that every investor should seek to answer relates to the reason for the elevated yield:
Does the high yield reflect an irrational, short-term decline in the stock’s price, or a fundamental change in the company’s outlook that will impact long-term profitability?
In other words, the challenge is to identify which component of the dividend yield calculation fails to accurately reflect the company’s future. If the share price is the component that is out of whack with the company’s future — if the high yield is the result of an irrational sell-off — then the stock could represent a major opportunity.
If, on the other hand, the historical dividend is unsustainable and expected to be significantly reduced (or even eliminated), investors may be staring into the teeth of a value trap. When considering this possibility, keep in mind that public companies aren’t invincible. In fact, failure is relatively common; 54 public companies filed for bankruptcy in 2014. At least that many public companies have filed for bankruptcy in each year since 1980.
A high yield may be a leading indicator of a slide into bankruptcy — or it may be a once-in-a-lifetime buying opportunity.
SPG in Focus
It isn’t always obvious which scenario is causing a high dividend yield. Simon Property Group (SPG), one of the largest owners of retail real estate, serves as an example. In the second half of 2008, SPG’s share price sunk, and its dividend yield skyrocketed:
The 10 percent yield certainly looked attractive in late 2008, and investors who chased it were handsomely rewarded; since bottoming out in early 2009, SPG shares have gained more than 600 percent.
But it certainly wasn’t a sure thing at the time. SPG slashed its dividend in 2009, which pushed the yield back into the single digits. As the company’s operations and cash flow stabilized, the yield gradually increased and eventually eclipsed pre-crisis levels.
In the case of SPG in 2008, the market capitalization was the component of the dividend yield calculation that failed to reflect the company’s outlook. Shopping malls survived the downturn, SPG’s rental income stabilized, and the company’s dividend yield quickly returned to (and then surpassed) historical levels.
SPG now pays out $6.40 in annual per share dividends — reflecting a yield of about 25 percent on the stock price highlighted in the chart above.
JCP in Focus
JC Penney (JCP) is another example of a high-yield dividend stock, with a very different outcome. In late 2008, JCP was yielding more than 5 percent after the stock had lost more than half of its value. That attractive yield, however, was relatively short-lived; JCP kept its dividend steady for several more years, but eventually elminated it altogether after turnaround efforts stalled and a challenging environment for department stores persisted.
Illustrated another way, the following chart shows historical JCP dividend payments (with Q1 2009 highlighted in yellow):
In this case, the historical dividend payment was the component of the yield calculation that wasn’t indicative of future results. Though the stock did recover from its 2008 lows, that rally was short-lived. Investors who bought in at the point of peak dividend yield have lost more than 50 percent in their JCP position and seen the dividend eliminated completely.
Tale of Two Stocks
Both SPG and JCP appeared on high-yield stock screens in early 2009 after their prices had fallen sharply. In one case, the stock decline was a significant overreaction: SPG was a tremendous opportunity that has delivered huge returns.
In the other case, the stock price decline reflected a deteriorating business: JCP was a classic yield trap that eliminated distributions completely and has seen its stock continue to slide.
The challenge, of course, is answering this question without the benefit of hindsight.
This article, High-Yield Dividend Stocks: The One Question Every Investor Must Ask, first appeared on Dividend Reference.