[Max]

I have heard that chasing yield is bad, but I would like to understand more fully what are the arguments.

A lot of the most highly recommended dividend stocks yield only 3-4%. I see some of these US shipping companies yielding 15-20%, and GE, BMO and others have all touched double digit yields. They look pretty tempting, but after hearing the don't chase yield comments, I hesitate and am compelled to think it through, but I cannot see the weakness.

Why should we not pursue companies like these assuming they pass a fundamental analysis of their financial health, they are paying out less than they earn, and they are not funding dividends with debt or common stock issuance?

Is it because dividend investors do not like to time the market and would rather make smaller regular purchases than large lump sum investments that they avoid high yielding stocks with high volatility? Is it because the high yield almost always signifies problems with the stock (its yield must be high for a reason?).

Could someone please let me know the common dangers of yield chasing?

 

[mfd]

Nothing is wrong with high yield really. You've touched on one concern though. Payout ratio. A high yield could mean a company is paying out a large portion of their earnings in dividends which doesn't leave them with much money to grow or they may even be going into reserves to pay the dividends. This will eventually lead to a dividend cut.

A second concern is inflation and dividend growth. A high yield today may not be a high yield in 20 years. They may pay out 15% now but if they never raise their dividend in 20 years it could be a yield of 1%. On the flip side a company that is currently paying out 1% today could be paying out a bundle in the future if they grow their dividend aggressively. This is why its important to look at both yield and growth.

Those are generally the two main issues. I'm not a heavy dividend investor right now so there might be a few more reasons that others can fill in.

 

[Financial Highway]

Yea you are right partially that stocks that have a high yield are SEEN to be in danger of cutting dividends, but not in all cases. Income trusts and REITS have high yields because they are required to distribute most of profits to shareholders, but just be aware with income trusts not all of it is dividends. It can be interest as well as return of capital ROC.

The higher yield you have the higher PERCEIVED risk you take to dividends being cut.

Shipping companies are very similar to income trusts, but VERY volatile it should only be very small part of your portfolio.

The danger is that if dividends are cut you will
1. lose/reduce your income
2. have a stock drop (15-30% maybe)

And if you are depending on the dividends as income support it will have a major impact on you e.g. Derek Foster.

What is more important when looking at dividends is looking at the PAYOUT RATIO. If the company is paying out 30% of their earnings there is enough room for profits to drop and maintain dividends. But if payout ratio is 80% if earnings drop chances of a cut are much higher.

Like i said yield is just perceived danger, it doesnt always mean it will happen. For example Canadian Banks have high yields, I don't think the banks will cut their dividends anytime soon, unless we have a major economical disaster at which point I think we'll have other things to worry about than bank dividend cuts.

here is my look at Are Canadian Bank Dividends Safe?

I think if you are buy-and-hold investor and going for long term do your DD and you can find GREAT dividend paying stocks with good yields.

Canadian Capitalist post on Dangerous of Chasing High Yield

 

[Max]

Great, great advice. Thanks guys!

 

[moneygardener]

Great answers here and I agree with most of the comments.

Another problem with chasing yield is overconcentration on one feature of a stock (company). If by 'chasing yield' the investor is drawn to stocks with high yields and pays little mind to other factors such as competitive advantage, balance sheet, earnings growth history and potential, return on equity, profit margin growth, need for product/service in the future, brands, etc. then it is a mistake just based on that.

If your stock screen is as simple as:
-Stocks yielding +7%

you have a problem.

 

[MoreMiles]

Yellow Pages was listed as a TSX 60. It was yielding 10% and lots of people were chasing it. What's wrong? Well... You know the ending.

 

[james4beach]

The problem with chasing yield is that it often ends up with you losing capital. When all is said and done your total return is back to market average (best case scenario) or, more likely, far worse than market average. I'll bet that a lot of people chasing dividend yields today will find that, in 10 years, they would have been much better off in XIU or ZCN.

At a more fundamental level, and this answer encompasses stocks, bonds & everything --

The problem with yield chasing behaviour is that the investor is stubbornly refusing to accept the reality of the market. Interest rates are all relative. The market currently tells us, via bonds, that the 5 year benchmark is 1.8% and the 10 year is 2.5%. These are the benchmarks.

So when an investor says "I want higher than the 3% dividend yield I'm getting on the TSX" they're really stubbornly refusing to accept the market reality. Currently, 3% is more or less the long term yield you can expect. But many investors seem to approach the market from the viewpoint that I need a predetermined X% (for my retirement planning) and therefore I'm going to make it happen.

And I think that's the wrong way to invest. The market doesn't owe you 5% returns. The bond market says that the no risk long term rate is 2.5%. I think as an investor you have to take that reality and work with it. Or at least you have to realize that any time you find more than 3% yield, there are some risks involved. But I routinely see people demanding more than benchmark rates, without realizing what kinds of risks they're taking on.

This is why I accept the 3% GIC yield and am happy with it. And why I buy the government bonds at 2.5% and am happy with those too. I acknowledge these are the current interest rates in our market, and I don't fight it.

 

[Rusty O'Toole]

Others have pointed out the danger of chasing yield i.e. many stocks and bonds have a great yield right before they go bankrupt. They could have been paying dividends out of capital, or even borrowing money to keep up the dividend.

On the other hand there are times when the whole market is selling at a discount or even a certain sector. There was a lot of doubt about the banking sector in 2008 - 2009 and this brought down the price of Canadian bank stocks even though they were in little or no danger.

Buying good stocks when they are on the bargain counter is an excellent way to "chase yield" as long as you investigate and make sure you are not buying into a dying concern.

Incidentally there are times when it pays to buy the securities of a bankrupt company. For example the Penn Central Railroad went bankrupt in 1970 or thereabouts. It was the biggest bankruptcy in American history up to that time. But I heard of one investor who made a killing in Penn Central bonds.

It was like this. There was a certain issue of bonds that had a high coupon, 12% I think. They were issued when the railroad was in trouble and their credit rating not the best. But, the bonds were secured by a mortgage on the rolling stock, held by another railroad.

One investor bought these bonds at 60 or 70 cents on the dollar during the bankruptcy. He knew he was going to get every penny of interest and capital because he checked into the bonds, checked into the railroad that held the morgage, and checked with the trustee in bankruptcy.

It took a year or 2 to work everything out but he got interest of 18% or 20% on his money plus a capital gain of half or 2/3 when they cashed out the bonds.

This was written up in one of Adam Smith's books, I think it was in Supermoney. He went on to ask this investor what stocks he liked and he recoiled in horror. "I never buy stocks" he said. "They go UP and DOWN all the time".

So, he was making 20% or more per year on his money and he never touched stocks because they were too risky.

 

[james4beach]

Buffett has been buying distressed debt for years. It's totally a valid thing to do (buying bonds or preferreds with high yields) but there are huge risks involved and you have to be an expert in those areas to really understand what's going on.

It's retail investors I'm concerned about. They wander across the web and end up buying some like XTR for its "high yield", an ETF that's loaded up on junk bonds!

 

[james4beach]

Those institutional investors who buy distressed bonds and other high yield things, also often face total losses on some of their purchases. But they have enough capital in the game to come out ahead after the big winners (the recoveries) balance out the losers. Again I don't think a typical retail investor can expect to replicate the performance seen by professional distressed debt investors.

 

[MrMatt]

Could someone please let me know the common dangers of yield chasing?

The danger is you might not get it. The published yield is trailing yield.

What if a company "yielding" 10% runs out of money and declares bankruptcy?

For a company paying out $10/share/yr, the "secure" one will have a high price (low yield), the "risky" one will have a low price (high yield).
Just think about that.

Most likely if you're getting a high yield, the underlying company is riskier than others, you're taking on more risk for that potential return.

Another thing is some resource trusts simply run out, what would you pay for an oil well that is almost dry vs one that is fresh and "full".

 

[Synergy]

"High Yield" and "Yield Chasing" is pretty subjective - what are we talking about - 2-3%, 3-4%, 5-6%, 7-8%, 10+%? Would you call an investor who screens for stocks in the 2-3% yield range "a yield chaser"? I view a yield chaser as someone seeking yield (usually in the 6+% range) with little to no regard to the companies fundamentals. Additionally, just because a company has a higher yield doesn't necessarily make it a riskier investment - small cap growth stocks paying no dividend are often riskier than a large cap stock paying a reasonable yield of say 3-5%.

 

[gibor365]

just because a company has a higher yield doesn't necessarily make it a riskier investment - small cap growth stocks paying no dividend are often riskier than a large cap stock paying a reasonable yield of say 3-5%.

Exactly! Take for example MO , they have 5.3% yield and raising dividends for 45 years (since I was 2 years old ) .... I doubt that their dividend is riskier than of some 1-2% yielding small cap. Yea, I bought MO about 2 years ago mostly because of the yield and because I like their product and now my YOC is 7.4%

 

[andrewf]

It's almost as if the dividend yield is not very useful in providing information about a company, and you should evaluate them on factors other than yield.

 

[gibor365]

It's almost as if the dividend yield is not very useful in providing information about a company, and you should evaluate them on factors other than yield.

Yield just one of the many factors

 

[MrMatt]

It's almost as if the dividend yield is not very useful in providing information about a company, and you should evaluate them on factors other than yield.

No one number is going to give you a complete understanding of a company.

 

[Charlie]

Interestingly, if OP had 'chased yield' with BMO or GE in April 2009 as he'd contemplated, he'd be up 250% in share price and a big up in dividends to boot . Better lucky then good, I suppose...

 

[HaroldCrump]

IMHO, we should differentiate between chasing yield and focusing on dividend growth.
Companies that are able to grow their dividends consistently year after year turn out to be great investments more often than not.

A few names come to mind such as IBM, Coca Cola, the 5 Canadian banks, telcos like BCE, utilities like Trans Canada, and a few others.

Such investments are often characterized by a high YOC.
I know, I know, YOC is supposed to be meaningless, however, there is often a highly compelling success story behind a high YOC that cannot be ignored.
It indicates a combination of good market timing as well as a good fundamental analysis success story.

Just as we should not make a fetish out of yield, similarly, we should not summarily dismiss and pooh-pooh the ability of a company to pay healthy and growing dividends over time.

 

[Synergy]

Just as we should not make a fetish out of yield, similarly, we should not summarily dismiss and pooh-pooh the ability of a company to pay healthy and growing dividends over time.

1+ Well said

 

[OnlyMyOpinion]

It's retail investors I'm concerned about. They wander across the web and end up buying some like XTR for its "high yield", an ETF that's loaded up on junk bonds!

We don't own any XTR but are interested to know how one determines that it is "loaded up on junk bonds"? If we look up the current fund holdings at ishares, they indicate having 17.6% in the iShares US high yield bond index - is that the "loaded up" part? But as an index, isn't the risk in turn spread so that having a single or several bond issues go bad would be a mere blip? It looks like the largest single holding within that bond index fund is 0.58% in someone called Sprint Corp. And back in XTR, it looks as if the largest position in what they call the 'aggregate underlying holdings' is 2.5% in Fortis, 1.95% in RioCan, etc.

We can see that the fund's recent performance has been poor, -0.61% ytd, 0.95 over 1 yr, but assume that might be because the bonds, prefs and reits it holds took a kicking this year? Are we missing something?