How often do you see articles on Seeking Alpha and elsewhere that highlight a high-yielding opportunity?
Those articles are very common because titles that include a high yield like 8% or 9% will commonly get a lot more clicks than a similar article highlighting lower-yielding companies.
It then isn’t surprising that so many authors cover companies like Energy Transfer (ET). But before you rush to buy just any high-yielding company, I wanted to write this article to give you a few important warnings.
We have been high yield investors for a long time and while we have been successful over time, we have also made a lot of mistakes along the way from which you can learn.
The high yield space can be very rewarding if you know what you are doing, but it can also be just as punishing to investors who are ill-prepared.
In what follows, we give you 5 different warnings to help you earn higher, but also safer income.
Warning #1: A Safe And Growing 6% Yield is Far Better Than a Risky and Stagnating 9% Yield.
The biggest mistake of most investors is that they will be too greedy and go for the highest yield at the expense of future growth and higher risk.
From our experience, the vast majority of companies that pay a high yield approaching 10% turn out to be poor investments in the long run. They may seem very compelling on the surface and you may even read a compelling article on them, but the reality is that if a stock is priced at such a high yield, there is typically a good reason for it.
Its business is struggling… the balance sheet is overleveraged… the management is conflicted… etc. As Buffett has famously said, time is on the side of a good business, but it is the enemy of a bad business. Eventually, the dividend gets cut and investors are left holding the bag.
We believe that most high yield-seeking investors would earn much better returns in the long run if they put more focus on getting the right combination of yield, growth, and safety, instead of just fixating so much on the yield.
In that sense, a safe and growing 6% yield is much better than a risky 9% yield in most cases. With that in mind, we would much rather buy W. P. Carey (WPC), the blue-chip industrial net lease REIT at a 5.5% yield than Global Net Lease (GNL), the conflicted office-heavy net lease REIT at a 9% yield.
Time is on the side of good businesses, but it is the enemy of poor businesses:
Warning #2: Temporarily Challenged Businesses in Good Sectors Are Superior to Well-Performing Businesses in Bad Sectors.
To earn a high yield, you will typically need to invest in somewhat challenged businesses. That’s simply because the market is unlikely to price a stock cheaply enough for its yield to be significant unless the company is affected by some sort of uncertainty.
But the key is to buy businesses that are only affected by temporary uncertainty, and not some permanent structural issues that can hardly be solved.
To give you an example, a few years back, we recall investing in a mall REIT called CBL & ASSOCS (CBL). Back then, it paid a 10%+ yield and many argued that the company was undervalued due to fears that were overblown.
In hindsight, investors were correct to be skeptical. While CBL’s mall portfolio had performed well in the years prior to the decline in its share price, its balance sheet was overleveraged to reinvest in its properties in what was an increasingly competitive landscape. Investors who went for the 10%+ yield got burnt badly.
Instead of buying high-yielding companies in declining sectors, investors would have done far better if they bought temporarily challenged businesses in stronger sectors.
During the pandemic, we invested heavily in utilities (XLU) that were temporarily challenged due to the disruption caused by covid-restrictions. We knew that this wouldn’t last forever, and as things returned to normal, our investments rose to new highs.
Warning #3: Payout Ratios Can Be Very Misleading in Assessing Dividend Safety.
We often see investors justify the safety of their high-yielding stock by pointing to their low payout ratios. I have seen this over and over again and it almost always ends badly.
The issue with payout ratios is that they tell you very little about the long-term sustainability of the dividend.
It is not uncommon for a company with an 80% payout ratio to pay a far safer dividend than a company with a 50% payout ratio.
The payout ratio ignores the quality of the assets, the sustainability of the cash flow, the strength of the balance sheet, and the alignment of the management.
A lot of investors bought heavily into Shell plc (OTCPK:RYDAF) pointing to its high yield, low payout ratio, and long history of dividend payments, but failed to recognize the issues that the company was facing.
Today, one of the most popular names on Seeking Alpha is a company called Omega Healthcare (OHI). It yields nearly 10%, its payout ratio is 80% and the company has a long track record of dividend growth. But does that mean that its dividend is safe? A lot of investors are too quick to assume so and they are paying the price:
Warning #4: Diversification is Not an Option. Even The Best Opportunity Has Significant Risks.
There is no such thing as a perfectly safe high yield.
If you are seeking high yield, it means that you are taking calculated risks, and despite how solid an investment thesis may sound, there is always a chance that the thesis fails if a risk factor plays out.
Therefore, it is absolutely key to seek proper diversification and avoid being overly concentrated on a single position or sector.
To give you an example: there are a lot of high-yielding opportunities in the MLP sector and as a result, high-yield-seeking investors tend to invest heavily in them. But if you were concentrated on MLPs, you would have lost a lot of money over the past 10 years:
Diversification would have protected you.
Warning #5: Being Selective Starts With Picking The Right Sectors At The Right Time.
We firmly believe that the majority of high-yielding stocks are poor investments. The market may not be perfectly efficient but it is not stupid either.
Therefore, if you want to succeed, you need to be very selective. At High Yield Investor, we only invest in ~2% of investments that we analyze:
Most investments are eliminated simply because they are in the wrong sector, which goes back to reason #2. We only look for businesses that suffer temporary challenges and operate in strong sectors with long-term tailwinds.
With that in mind, we invest most of our capital in the following sectors at this time:
Many utilities are still discounted due to the temporary pain caused by the pandemic, but their long-term outlook is unchanged. The same applies to a number of infrastructure and energy companies.
Generally speaking, we think that in today’s world of high inflation and low interest rates, investors should overweight real asset heavy sectors and that’s exactly what we are doing.
Bottom Line
If there is one thing to take away from this article, it is that you should think twice before going for 8, 9, 10%+ yielding stocks. Many of them look good on the surface but are rotten on the inside.
Instead of going for the highest-yielding stocks, you should target companies that offer the most optimal combination of yield, growth, and safety. Generally speaking, that leads us to invest mainly in 5-6% yielding companies in today’s market:
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