Issue 177, 08 June 2005
Investor's College Danger in dividend yields A high dividend yield can indicate there's value in a stock, but there are plenty of traps for the unwitting investor. If you’re anything like us, you probably enjoy running your eye down the dividend yield column of your favourite financial pages. As far as yardsticks for value go, a high dividend yield is one of the most straightforward. Unfortunately, simplicity doesn’t equate to reliability and many investors end up buying high-yielding stocks that turn out to be absolute dogs. It’s a topic we discussed in our More to income than yield article of issue 136/Sep 03, which we recommend reviewing. In this article we’re going to suggest some specific questions you might like to ask next time a stock with a high yield jumps off the page at you. First and foremost The first and most important question is: ‘Do I understand exactly what this investment is?’ This gets back to the words Ben Graham wrote in chapter 20 of our namesake, The Intelligent Investor: ‘Investment is most intelligent when it is most businesslike.’ Many people shop around to save a few hundred dollars on their whitegoods, or even a few cents per litre on the price of petrol, but then invest thousands of dollars after minimal research and only a few minutes of thought. We suspect the problem is that a lot of people don’t know where to begin, so they take a deep breath, place the buy order and hope for the best. If you take the following pledge, we guarantee your investing results will improve: From this day forward I shall never place a single dollar in an investment which I do not understand. I will undertake any required research and not be afraid to ask ‘silly’ questions of anyone who has recommended a stock or product to me until such time as I am comfortable with the nature of the investment and the risk it entails. By taking this pledge, you will avoid being surprised by unconventionally structured investments such as Bass Strait Oil Trust which, according to some papers around the country, has a dividend yield of more than 15%. Those who read issue 136/Sep 03 of this publication will know better than some of that stock’s owners, we suspect. Cyclical stocks As investors in Mirvac have discovered the hard way, there’s a world of difference between investing in a cyclical stock and one that has a long history of steady dividends. A cyclical downturn in an industry prone to such swings can leave your dividends looking somewhat anaemic, especially in comparison to any fat cheques received in boom times. Ask yourself whether the stock you’re considering is cyclical. If you don’t know, then you’re probably already in danger of breaking the pledge you took a few moments ago. Low-quality businesses We’ve done more than our share of PaperlinX-bashing in recent issues but it really does fall into this category. No dividend carries an iron-clad guarantee, but those that emanate from businesses without a sustainable competitive advantage generally entail a higher level of uncertainty. And, in our view, most businesses listed on the ASX do not possess a sustainable competitive advantage. We’re still prepared to buy such stocks at the right price, but it takes more than a high dividend yield to convince us. Before buying, always ask yourself where a stock sits on the quality spectrum. Faux dividends While metaphysics may not be your strong suit, it’s important to ask yourself whether a dividend is real or imaginary. Some companies go to great lengths to look like they’re paying out cash to shareholders when they’re really doing no such thing. For a good example, review the case of National Australia Bank’s underwritten dividend reinvestment plan (DRP), which we analysed in Understanding underwritten DRPs in
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issue 152/May 04. Not far behind the devious fully underwritten DRP, sits the highly discounted DRP. In such cases, each individual shareholder feels like they’re getting a bargain by participating in the DRP at an attractive discount to the current market price. But the reality is that large discounts practically force sensible investors to participate in the DRP. The upshot is that the company retains the money, most shareholders end up with the same percentage ownership (everyone owns a greater number of shares but there are correspondingly more shares on issue) and shareholders have to find the cash to pay tax on a dividend that they never actually deposited in the bank. Management teams undertaking such programs, including paying dividends while raising new capital through share issues, either don’t have shareholders’ interests at heart, or are financially illiterate. AMP was guilty of such a shareholder offence in 2003 when it declared a partly franked dividend with a fully underwritten DRP, and then promptly undertook a $1.2bn rights issue. And, ironically, financial education group Tribeca displayed an embarrassing lack of fiscal acumen last year when it launched a share purchase plan at the same time as paying unfranked dividends. Listed investment companies If it’s a listed investment company (LIC) you’re considering, ask about its philosophy on dividend payments. Some LICs make a big effort to pay a ‘sustainable’ level of dividends. Australian Foundation Investment Company and Argo, for example, have long histories of gradually increasing their ordinary dividends, and paying special dividends when times are particularly good. Others, such as Templeton Global Growth Fund, pay dividends in line with their yearly investing returns, which can vary significantly depending on market and currency movements. Asking these questions before launching into a high-yielding stock should help you steer clear of a lot of trouble. Next issue we’ll consider a few stocks that are currently offering high yields to see if we can’t sort the wheat from the chaff.
C o p y r i g h t © 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288. PO Box 1158, Bondi Junction NSW 1355. Ph: 1800 620 414 Fax: (02) 9387 8674 WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all subscribers.
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