Avoiding The Stink Of High Yield – How Much Is Too Much?

It’s long been a goal of mine to have a dividend income that roughly matches our family’s annual expenses.  I say *roughly*, because in any given year we might have a random irregular expense that causes us to overspend our cash generation a little.

(The purchase of a new car, an expensive family vacation, or repairing the roof on our home would be good examples of this)

This year, I’m going to be pretty close to that goal (assuming I meet my 2019 dividend growth plans).

It’s no secret that having significant cash flow from investments is a good thing.  During inopportune market moments we’re not forced to sell assets to meet our cash requirements.  We’re also not forced into poor capital allocation decisions that would favor lower annual cash requirements.  (For example, I can continue to hold onto my mortgage without worry because of our significant cash flow)

Yet I actually try to talk down other investors trying to replace job income with dividend income.  Why?

High yields kind of stink.  Investors often make the critical mistake of chasing unreasonably high yields, in unwitting attempts to reach their dividends goals sooner.

Our Portfolio Yield

Let me say it again — Chasing high yield is a dangerous activity I actively recommend investors avoid.  Avoid it like a horrible disease!

Yes, you’ll gain a larger dividend income in the short-term, but longer-term you trade increased income for significantly increased risk — High yielding companies often have unsustainable high payout ratios, poor growth levels, and very high debt levels.

In a worse case scenario, the dividend could be cut — and this usually means vast under-performance.

There’s even evidence to suggest that high yield portfolios could increase your Sequence of Return Risk.

There’s always exceptions of course — Investments that can sustain high payout ratios and still keep debt levels manageable… even during a recession.  But those are exceptions, rather than the norm.  (In fact, I might cover some potential exceptions in my next post!)

Most of the time though, we want to avoid such high-yield investments.

So rather than continue to lecture on like some stodgy professor, I thought it best to teach by example.  Here’s how our portfolio yield breaks down over the last few years:

Notice that the values above are only for our taxable accounts.

(As you can see, 2015 was an exceptional year for dividends and should not be considered our normal.  This was a special case where one of our investments was purchased by another company, and that purchase included a large dividend payout.  Under “normal” dividend conditions we would have only earned a portfolio yield of 3%. )

While 2019 isn’t over yet, I’m projecting dividend income of roughly $57k — which means a portfolio yield of around 2.68% this year.  The final 2019 number could come out to be slightly higher or lower, but I wanted to provide a reasonable projection for 2019.

As you can see, our overall portfolio yield has drifted lower in recent years.  There’s several reasons for this:

• Our cash pile is building up, due to expensive equity prices.  Cash in our money markets earns roughly 2%.
• Many of the preferred shares we purchased back in 2009/2010 have been slowly redeemed in recent years.  These have been replaced with lower yielding stocks.
• A intentional movement to “safer” equities as the bull market wears on.

Did you expect the yield to be higher?  I bet you imagined it was!  With the S&P 500 index yielding around 1.87%, I wouldn’t consider our 2.68% portfolio yield to be terribly high at all.

How Much Is Too Much?

After telling people all the wonderful reasons why they shouldn’t chase yield, the next question I always get is: “How much is too much dividend yield?”

Giving a decent answer to this question is a little tricky — it’s entirely dependent upon what you hold in your portfolio.  A stock that yields 3% could still be less risky than another stock yielding 2%.  It totally depends upon the stock price, the payout levels, debt levels, and even the industry in which the investment exists.

There’s no easy answer.

Knowing the great difficulty in making this kind of determination, I still tend to go by a few “rules of thumb” when finding safe dividend payers:

• Look for a payout ratio less than 60%.  A payout ratio larger than 60% is potentially dangerous.  There are exceptions to this rule, but investing in stocks that pay less than 60% of earnings are typically pretty safe.
• Look for stocks that maintain a debt to equity ratio under 1.5. Companies funded with too much debt (instead of equity) have a tendency to cut dividends when the going gets rough. I generally look for stocks with lower debt to equity levels.
• Avoid industries that have boom and bust periods due to fluctuating commodity prices.  The oil industry is a great example of this.  When oil prices were good, Kinder Morgan (Stock symbol: KMI) paid a very large dividend.  All that changed in 2015 when the price of oil crashed and KMI needed to cut their dividend by 74%.  Despite 3 more years of bull market, the stock price has yet to recover.
• Search for investments that have the ability to grow by investing excess free cash flow (aka internal compounding).  If the company needs to borrow significantly or issue equity in order to grow, this could be a warning sign. (Especially in an era of rising interest rates!)

Are these rules of thumb perfect?  No, absolutely not!  Sometimes even when you adopt fairly conservative guidelines like this, the world can throw stinkers at you…

Beware Fallen Angels With High Yield

It stands to reason that companies that pay dividends are loath to cut that dividend when they run into trouble.  They obviously don’t want to be tainted with the “dividend cutter” status, because that leads to massive share under-performance.

As a result, companies will do whatever they can to maintain to an already established dividend.  Some will even sacrifice the future health of the company to pay present dividends.

“Fallen Angels” are stocks that were once the darling of stocks investors — known for being titans of industry, with fast growing stock prices, reasonable leverage levels, and growing dividends.  For one reason or another these “Angels” fall on hard times.  Profits decline, and suddenly that once conservative dividend yield becomes a very big problem.

General Electric (Stock Symbol: GE) is one such “Fallen Angel” that’s fallen from the heavens in recent years.  Back in the 1990’s and early 2000’s, GE was growing earnings and dividends at an incredible clip.  It was a titan of industry.  Then in 2008 it faltered, and profitability declined.  The business never recovered, yet the stock continued to pay it’s quite large dividend…. never cutting it despite continued earnings shortfalls.

IMHO, the need to maintain that high dividend relative to low earnings significantly contributed to the decline of GE.

It’s a situation that sucked in many great investors, thinking the “Fallen Angel” would return to its once former position among the heavens.  Unfortunately GE cut it’s dividend last year, and it looks increasingly unlikely to ever recover it’s former titan status.

GE’s definitely got ‘the stink’ on it now.

So let this be a lesson to investors:  Beware fallen angels offering high yield.  Reputation alone cannot support a large dividend.  Only cash flow from a profitable business can be used to pay dividends.  While short-term borrowing can sustain a bad quarter or two, investors should keep a VERY close eye on the financials when this happens.

As Warren Buffett once said, “Turnarounds seldom turn.”

In general, I try avoid Fallen Angels for exactly this reason.  Investors tend to focus too closely on the dividend yield and past glories, not on the current conditions of the business.  (A deteriorating business rarely goes back into growth mode.)  This what I call a value trap.

If you’re curious, I also have a few additional thoughts on avoiding value traps that might be useful.

Final Thoughts

Retirees are often look to replace job income with investment income, and they frequently fall for the trap of hunting for high yield.  It’s a dangerous trap to fall into, and it stinks when you get caught.

Even the great companies of today (with reasonable dividend yields) can become the high-yield monsters of tomorrow.  What looks safe today, might look entirely unsafe under different economic conditions.  It’s important to remember that the world is always changing, and high yields are one way investors get tripped-up.

That’s not to say dividends are a bad thing.  Not at all!  Income is an incredibly important part of investing, and should not be entirely discounted in favor of 100% capital appreciation.  Both internal and external compounding should play a part in your portfolio.

Just don’t over do one or the other.

Now it’s your turn — Care to share your portfolio yield in the comments below?

[Image Credit: Flickr]