Why It Is Dangerous to Invest Based on Dividend Yield

If something seems too good to be true, it’s probably because it is.

Unfortunately, most writers and investors do not look much further than the actual dividend yield number. They fail to ask a very basic question. Why does the company pay such a high dividend yield? Of the various possible explanations very few are positive.

Explanation 1:
The stock price has been decreasing in value driving up dividend yield (yield = dividend/stock price). When the price of a stock declines, more often than not the market correctly estimates that a company’s prospects are not good or at least worse than its competitors’.
Explanation 2:
The company pays out a large share of its profits because it lacks attractive investment opportunities. In the absence of attractive investment opportunities, a company is very unlikely to create value over the long term. Its only options are to maximize operating efficiency and buy back shares. But you do not have to be a star investor to realize that there are hard limits for this.
Explanation 3:
In spite of very dim prospects, the company continues to pay a high dividend to keep investors happy (thereby preventing a big sell-off in the company’s stock). This is probably the worst scenario. Many REITs specialized in the hard hit retail property space have been doing this. Washington Prime, Seritage Growth Properties are just some examples following this strategy until the cash ran out.
Explanation 4:
This is the only acceptable scenario in our view. Companies with long investment cycles and long stable cash flows fit the bill. You can find these in certain parts of the real estate industry or amongst the pipeline operators. But you have to be sure to pick the best of the best.

Checking the numbers

This is where Ziggma’s stock ratings come in. But let’s check the facts first. Using our free stock screener, you can also run the numbers yourself.

Currently, there are 74 companies in the US with a marketcap greater than $ 1bn that pay a dividend yield greater than 7%. This sounds like a lot of opportunity.

However, a closer look reveals a less pretty picture.

Many of these companies do not have solid balance sheets: 64% have a Ziggma financial position sub-score < 50.
More than half of these companies have not experienced profit growth over the past 5 years: 53% show 5-year CAGR earnings growth < 0.
No growth and below average financial position: 31% show 5-year CAGR earnings growth < 0 and a Ziggma financial position sub-score < 50.

Two conclusions

1. Companies with a high dividend yield tend to have low or even negative long-term earnings growth
2. Many companies with a high dividend yield tend to have sub-par balance sheets.

Takeaway

It turns out that high dividend yields are too good to be true. Even though a high dividend yield is very enticing, the financial performance of companies with high dividend yield rarely is.

Instead, growth is the key to successful investing. Value creation happens where the growth is. This does not mean that you should now look for the companies with the most massive growth rates.

Rather, as a long-term investor, you should look for solid long-term growth, combined with good profitability and a robust balance sheet, ideally at a reasonable price.

And this is where our proprietary Ziggma Stock Scores come in. A high Ziggma Stock Score reflects that a stock does well on balance against its industry peers in the categories growth, profitability, valuation and financial situation.

Meet our Sustainable High Yield model investment portfolio

While the takeaway from this article is that there is only one stock out there with dividend yield greater than 7% and a marketcap of over $ 1bn that fits the bill, constructing a solid diversified portfolio generating material and sustainable income is possible. We have constructed just such a portfolio in the Ziggma Model Portfolio called Sustainable High Yield. It generates a weighted average yield of well over 5% from a well-diversified mix of companies from a wide range of industries.

The overall portfolio quality is very solid, as shown by the following aggregate portfolio metrics:

Average revenue growth: 4%
Average net margin: 22.8%
Average financial position score: 74

We are confident that this portfolio will provide for sustainable dividend stream over the mid to long term. You can find a few more sustainable dividend stock pick in this article.

Monitoring the Sustainable High Yield model investment portfolio

Ziggma provides many novel investment portfolio management tools. We focus a great deal on portfolio monitoring tools to make investing easier and less time-consuming for our users.

This starts with the intuitive portfolio dashboard, the comprehensive Portfolio Overview and extends to Ziggma’s smart alerts. These are a user favorite as they let users shift the burden of portfolio monitoring to Ziggma, freeing up time spent monitoring risk, diversification or portfolio quality.
Thanks to sliding scales, smart alerts can be set in a matter of seconds. For example, a user would like to be notified as soon as a position makes up more than 15% of his or her portfolio to avoid concentration risk (read too many eggs in the same basket). The user will then set the alert using the sliding scale placed right below the diversification chart.

Once this is done, he or she will no longer have to worry about concentration risk because Ziggma monitors this on the user’s behalf. Once the event materializes, he or she is notified immediately.

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Why It Is Dangerous to Invest Based on Dividend Yield.

High dividend stocks are all the rage