High-yield stocks have a number of lessons to teach. The inherent uncertainty means that there is a wide range of possible outcomes in both directions. Below are five principles to keep in mind, as illustrated by historical performance charts.
Lesson #1: Energy can be excruciating.
Before investing in high-yield dividend stocks, it’s wise to conduct a thorough review of a company’s operations. In most cases, this provides at least some insight into the direction the company is heading and the potential challenges that lie ahead. It may become possible to make an educated guess about whether a turnaround strategy will work, a new product line will flop, or profit margins will hold.
Predicting changes in commodity prices, on the other hand, can be a crap shoot. The relationship between the fundamental factors that ultimately drive commodity prices is incredibly complex and constantly evolving. Stocks of oil and commodity producers depend in large part on prices for the underlying resources — which means that they can be wildly unpredictable. The following chart for Kinder Morgan (KMI) is one of countless examples of the volatility that comes with energy stocks and MLPs.
If you’re considering high-yield energy stocks, be realistic about the possibilities. You’re ultimately speculating on the outcomes of several unpredictable events beyond the control of a company’s management. There are certainly opportunities to put the odds in your favor, but guarantees are hard to come by here.
The greatest management team in the world would have struggled to grow earnings at ExxonMobil (XOM) or KMI over the past couple of years. While the executives certainly impact the company’s operations, there are external factors that are outside of their control.
Lesson #2: Sometimes dividends just disappear.
High dividend yields are often the sign of a distressed company — and sometimes an immediate precursor to a dividend yield of zero. When companies encounter major challenges, the track record becomes meaningless.
The dividend history of Chesapeake Energy (CHK) is shown below. In July 2015, CHK announced that it was eliminating its dividend entirely. After steadily increasing for more than a decade, the yield dropped to zero overnight.
When things got tough, the 51 previous distributions didn’t mean anything. Those who had been watching Chesapeake’s quarterly filings (as well as oil prices) probably weren’t all that surprised by this development. But those who focused only on the 9 percent yield on the stock in July 2015 may have been caught off guard.
Lesson #3: Sometimes the market is very, very wrong.
High yields are sometimes an illusion that appears after trouble has arisen at a company but before the payout has been slashed. But sometimes high yields reflect incorrect assumptions about the risk associated with a company. McGraw Hill Financial (MHFI) was yielding more than 5 percent in early 2009 after shares had lost about half of their value.
In this case, the dividend wasn’t going anywhere. Looking at the MHFI dividend paints a much more soothing picture of the company’s operations; volatility is non-existent (the yellow column shows the point at which MHFI stock bottomed out).
MHFI is one of many stocks that was seriously mis-priced in early 2009. The market was wrong, and investors who snapped up the 5 percent yield generated some huge returns.
Lesson #4: The goal is to be right … eventually.
In an ideal world, investments in high-yield stocks would become winners the minute the trade settled. In reality, there are ups and downs in any stock — even those that end up as big winners. Suppose that you bought Vornado Realty (VNO) in October 2008, after the stock had plunged from $60 to $40 and the yield was around 6.5 percent.
This was a great buy…eventually. But first, it was a bad one; the stock dropped to $23 over the next four months before beginning a climb to $100.
Finding undervalued, promising stocks is certainly possible. Picking an exact top or bottom, on the other hand, can’t be accomplished with any consistency. Sticking with VNO as it lost almost half of its value in this scenario would have been challenging — and many investors no doubt bailed before the real run-up began.
Lesson #5: Sometimes dividend cuts work.
A dividend cut is, in many cases, the beginning of the end for a stock. The news of a cut is almost always accompanied by a defiant quote from the CEO, stating his or her full confidence that the company will turn around and be stronger than ever.
That scenario usually doesn’t play out. Restructurings tend to drag on, cash piles dwindle, and the stock price slowly but surely slides. But that isn’t always the case; sometimes a dividend cut helps a company preserve cash and fund a turnaround.
Ford (F) cut its dividend in 2006 as the entire auto industry flirted with collapse. But the strategy worked; the company avoided bankruptcy, and has now begun paying a dividend once again. F is up more than 700 percent from its 2009 lows.
The Law of Sometimes
The biggest lesson that can be learned from historical charts and stories is that each situation is unique. Sometimes the market knows a dividend cut is coming, but sometimes the crowd is way off the mark. Sometimes dividend cuts are a sign of fiscal discipline that will fund a dramatic turnaround, but sometimes they indicate a slide into bankruptcy.
Rules of thumb can be useful, but they certainly can’t be set in stone.
This article, Lessons from the Best (and Worst) High-Yield Dividend Stocks, first appeared on Dividend Reference.