Digging Deeper to Avoid Yield Traps

by Colin McWey of Heartland Advisors, 11/19/16

Executive Summary:

  • The chase for dividend yield has created bloated valuations in some sectors.
  • Free cash flow yield can provide insight into a company’s strength.
  • Paying out too high a dividend can limit a company’s path forward.

The hunt for dividends has shown little sign of slowing. Through the first nine months of the year, the top 30% of names based on yield in the S&P 500 outperformed the remaining stocks by more than 900 basis points on average. Other major indices have seen similar results as the struggle to replace income formerly generated by bonds continues.

The upward climb coincides with nearly eight years of historically low yields for fixed income. Adding to the effect is the heightened importance placed on low-volatility/high-momentum stocks. The combination creates a feedback loop where stocks are bid up for their yield and then additional buyers enter because shares have performed well and price movements are stable.

A Widespread Issue

Utilities and Real Estate Investment Trusts (REITs) top the list of sectors where the pursuit of income has produced frothy valuations. Despite a third-quarter pullback in power companies, the sector in the S&P 500 still trades at 17.1x estimated 2017 earnings—well above its 20-year average of 13.6. Real estate is at similar levels. While the two areas are the most obvious, the phenomenon is widespread.

Yielding to Reason

Many of our portfolios have a dividend focus, including our Mid Cap Value Strategy, however, we believe a process that focuses solely on the ratio of payments to share price is shortsighted and could be costly over the long term. Instead, we look at current dividend rates as a single piece of a bigger picture including free cash flow yield and payout ratio. Using these two measures is consistent with our long-term value focus.

Even the most attractive dividend rates will lose their appeal if they become unsustainable. To that end, we look at how much income a business generates after paying its expenses as an indicator of whether cash distributions will endure. If a company’s cash flow is shrinking, it likely won’t be able to continue to pay investors at current levels. However, a business that generates increasing profits is better positioned to maintain or expand dividends.

Too Much of a Good Thing?

While dividends can be a welcomed aspect of total return, as long-term investors we want management to be prudent about the amount of income it returns to shareholders. We look to payout ratios to help gauge whether a business is being too aggressive in distributing cash. Put simply, businesses that are paying out a relatively small portion to shareholders have greater flexibility to increase dividends in the future or could use retained cash to invest in expansion or pay down debt.