High yield stocks
High yield stocks are like the little girl who had a little curl. When they’re good, they’re very very good, and when they’re bad, they’re horrid. A good high yield stock pays you a regular income of above 5%, and increases the share price. It’ll make you rich. A bad high yield stock is all promise and no performance, and some actually go bust. It could wreck your portfolio.
Always ask: why is the yield so high?
So how do you find the good ones and avoid the bad? One thing you should always consider is why a given stock is trading on a high yield. Is it because it’s in a sector that no one loves? Back in 2002 you could buy some excellent tech firms that paid dividends on yields of 4 and 5%, because the tech bust had decimated their prices. They were hit just as hard as the unprofitable internet no-hopers – investor dislike is contagious. If you bought those stocks then, you’d have easily doubled your money in a year.
But be careful; sometimes no one loves a sector for a good reason. Right now, plenty of retailers are paying good yields, but with Amazon taking more and more of the market, are those yields at risk?
Recovery stocks can pay great yields
A stock might also pay a good yield because it’s had a tough couple of years. Buying recovery stories can be a great way to acquire quality businesses at a price that gives you a good return. But again, you need to look hard at the particular circumstances before you make a decision.
Run the numbers
Avoiding the bad stocks is made much easier if you pay attention to a couple of statistics – the payout ratio and balance sheet gearing. If the company pays out only a quarter to half its net income as dividends, in a bad year for earnings it could still pay the dividend. If it pays out nearly 100% of income, and it’s in a fast changing industry like tech or retail, that dividend could be at risk. Again, if the company has lots of cash in the bank, your dividend is probably safe; if it’s heavily indebted, the banks are first in the queue. You’ll only get your dividend if there’s money left after the banks have been paid.
REITs and MLPs – high yield by design
However, there’s some stocks are designed specifically to pay good dividends. They’re actually intended to have a 90% payout ratio, and they’re based on strong, sustainable income streams. These are Master Limited Partnerships (MLPs) which invest in energy infrastructure such as pipelines, and REITs which invest in real estate. Their special status lets them pay investors out of untaxed income. With a REIT you’re getting paid rental income pretty much as if you were a direct landlord, less the management charge.
Because they invest in real estate, REITs have good asset backing. Those assets ought, over the long term, to increase in value, too. That means you get the best of both worlds – high current income and good long term potential for capital growth.
You won’t want to put 100% of your funds in REITs or real estate funds, nor in MLPs. But mixing some REITs into your high yield portfolio will boost your returns. And since REITs don’t trade in line with the stock market, they’ll also give you welcome diversification.