Thursday, September 18, 2008

High yield stocks for current income

The typical stocks that I currently focus on and own are ones that spot current low dividend yields which are pretty close to what I would get right now if I bought one of the most popular ETF’s such as SPY or DIA. The main difference is that based off the recent history of the stocks that I analyze, I have concluded that my selections have a chance of increasing their dividends above the rate of inflation, effectively doubling my yield on cost after a maximum period of 10 years. This sounds even more exciting as most of the dividend stocks I follow tend to increase their stock prices over time as well, thus effectively keeping their current yield low. At the end of the day this provides for a great total return experience as well as a stable and increasing dividend income.

Many readers of my column on my blog as well as seekingalpha have concluded that low current yields are not enough for them to live off of, and that the likelihood of future dividend increases does not seem as likely to them as it looks to me.

The yield hungry investors find refuge in high-yielding special treatment entities such as Real Estate Investment Trusts, Business Development Companies, Canadian Income Trusts, Master Limited Partnerships as well as some of the oil tanker stocks. The current yields on most of these stocks ranges from 4-5% for some REIT’s to over 20% for some BDC’s and tanker companies.
The reason why most of these companies are able to pay such a high dividend is because they use their cash flows rather than earnings per share in order to determine the payout to shareholders. Thus they add certain items like depreciation expense back to the earnings per share number and are able to increase the payout. Depreciation expense is basically an accounting term which means that the company is recognizing a charge to its fixed assets based off an amortization schedule. Thus if a building had a useful life of 30 years depreciated using a straight line method, and it sold for 30 million dollars, then for this example the company would have an annual depreciation expense of 1 million/year. The main problem is that on year 30 the building is no longer useful, and could be sold for a very small amount relative to what the REIT paid for it 30 years earlier.

In my understanding of this procedure, it seems that what most of these companies reward their stockholders is a return of capital, as opposed to a return on capital. That’s why most of the above mentioned typed of entities need to constantly sell more stock to investors or increase their leverage exposure in order to grow. As long as these stocks also have the ability to generate earnings however, which are directly proportionate to the returns on assets that the company typically generates, there shouldn’t be a worry for investors.

If that type of company stops growing however by issuing stocks and fixed income to investors, then the end result is that investors would not get a good total return at the end of the day.
Another risk with those entities mentioned in the second paragraph is that the government could change the regulations that govern certain aspects of these special entities like taxation for example. I tried explaining this in my article on Canroys several months ago.

So should investors invest in these higher yielding instruments? I would say go for it if you really need the high yield now, but remember that bad diversification and extreme concentration to the financial sector would have been detrimental to your portfolios in 2008. Thus, in order to maintain a balanced stream of income, one needs to have a diversified portfolio of stocks which includes as many industries as possible, without being overly exposed to any. If you can afford to wait for several years before needing the dividend income stream, then I would strongly suggest investing in stock with moderate current yields but good dividend growth potential.

And last but not least, even though dividend growth policies could always change, the dividend payments could always be cut. Thus always try to understand the business of the stock you plan on investing in as well as the reason behind the above average yield.

Relevant Articles:

- The price of higher current yield -Canadian Royalty Trusts
- The number one reason why i don't chase high-yielding stocks.
- The Rule of 72
- My Dividend Growth Plan - Stock Selection

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