When high yields are too good to be true

With bond yields still near historically low levels, investors have increasingly focused on higher-yielding equities to provide cash flow. And there are certainly a lot of companies that pay dividends available. But sometimes the higher yields are just too good to be true.

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When looking for dividend stocks we typically avoid the highest yielding names and look instead to those that yield less but offer greater sustainability characteristics.

We ran a backtest on Bloomberg to provide some clarity. With 13 years of available data, we broke the TSX down into deciles. Based on yield, the top decile contains the highest-yielding stocks, the second decile the next 10%, etc. Rebalanced monthly, we tracked the performance of these groups over time.

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The findings clearly support the strategy of avoiding the highest yielding and focusing a little further down the spectrum; specifically, avoiding the top-yielding 10% and focusing on the next two deciles. While the top-yielding decile has nearly twice the dividend yield (8.6% vs. 4.7% for the second and third deciles) the lower-yielding group significantly outperformed. Furthermore, it did so with less volatility.

When one of the highest-yielding companies falls, they tend to fall fast and hard. Often, the highest yield is simply unsustainable.

Fundamentally, companies in the second/third decile group possess a higher margin of safety in the sustainability of the distributions. The median dividend payout of ratio for the top decile is 124%, while the payout ratio in the second/third group is 85%. That’s still high, but more reasonable.

One of the metrics we use is the Bloomberg Dividend Health score. It measures the health of a dividend, incorporating earnings, payout ratios, balance-sheet leverage and free cash flow. It also looks at the direction metrics are trending in. The second/third decile group has an average Bloomberg Dividend Health score of +4, while the highest-yielding decile is -9. Positive is good, negative is bad.

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Gareth Watson is the Vice President, Investment Management & Research at Richardson GMP in Toronto. This team of research experts is responsible for monitoring and interpreting economic, geo-political situations, current market environments and trends. @Gareth_RGMP