The Dangers Of A High Yield

Published in Investing Strategy on 1 June 2010

Lessons from a three year old spreadsheet.

To investors looking for income, shares offering a high yield offer a double attraction.

First, of course, there's the higher than average income that the high yield offers. And second -- because yield increases as a share price goes down -- there's every prospect of a re-rating eventually bringing some capital appreciation.

I'm something of a High Yield Portfolio investor myself, as it happens. While a lot of my portfolio is tied up in index trackers and funds, most of the individual shares that I hold for the long term are high yield income plays.

Here be dragons

Of course, there's a danger to high-yielding shares: when is a high yield too high? When does that high yield, in short, indicate investor concerns about bad news lurking in the pipeline -- a dividend cut, a corporate banana skin, or fears about the long-time viability of the business or its profit margins?

Certainly, when you look at companies with yields that are far, far higher than average, it's not difficult to spot companies facing challenges. BP (LSE: BP), for instance, is currently offering one such yield at the moment, its share price driven down on fears of the costs incurred cleaning up (and stopping) the oil spill in the Gulf of Mexico.

Thanks, StepOne!

As it happens, back in June 2007, I spent two or three evenings analysing the FTSE 100's yields, using the excellent spreadsheet periodically posted by Fool reader StepOne.

My intention was simple: to see if I could determine at what point a high yield indicates a problem, rather than an opportunity offered by mis-pricing. At the time, you'll recall, the credit crunch had yet to hit (it was just weeks away), and Foolish high yield investors posting on the discussion boards were debating that very question.

Fifteen companies, it turned out, had a historic yield in excess of one standard deviation above the mean. And if that statistical language means nothing to you, translate the preceding sentence to read: 'fifteen companies had yields sufficiently high so as to be suspicious'.

Top of the flops

And here they are, in descending order of highest historic yield, with the share price in June 2007 compared with the price a couple of weeks ago -- 15 May, the date of StepOne's last high yield spreadsheet.

Note, in calculating the percentage rise or fall in the share price over the period, I've ignored the effect of rights issues, mergers and other dilutive corporate actions.

Company10 June
2007
15 May
2010
Percentage
+/-
Lloyds Banking Group (LSE: LLOY)568p58p-90%
United Utilities (LSE: UU)753p521p-31%
Severn Trent (LSE: SVT)1,487p1,128p-24%
DSG International (LSE: DSGI)165.4p28.2p-83%
Bradford & Bingley401.5pN/A 
Alliance & Leicester1,115pN/A 
Kingfisher (LSE: KGF)238.3p226p-5%
HSBC (LSE: HSBA)931p648p-30%
Friends Provident (LSE: FP)187p79.2p-58%
Royal Bank of Scotland (LSE: RBS)657p47.2p-93%
Barclays (LSE: BARC)723p309p-57%
BP (LSE: BP)563p530p-6%
Aviva (LSE: AV)770p327p-57%
Legal and General (LSE: LGEN)147.4p79.2p-68%

Danger sign

I think the table tells its own story. While the broader market is down, of course -- June 2007 marked the peak of the pre-credit crunch bull market, with the FTSE 100 closing at 6,732 on 15 June 2007 -- the number of companies that have since experienced serious adversity is worrying.

It's also instructive to look at the next five companies on the list: Rexam (LSE: REX), GlaxoSmithKline (LSE: GSK), HBOS, National Grid (LSE: NG), and Scottish and Newcastle, each of which hovered just below the cut-off point of one standard deviation.

Only two of those five have survived problem-free -- and of those two, National Grid has recently upset investors by announcing an unwelcome rights issue.

In short, a high yield can be an income investor's friend -- but also his enemy, unless other evaluation criteria, such as dividend cover, are carefully applied. And even then, problems can arise.

But that's the subject of another article.

More from Malcolm Wheatley:

> If you're in the market for buying shares, consider opening an online broker account with The Motley Fool's Share Dealing Service. You can buy and sell shares in real time for a flat rate of just £10. Click here to open an account for free today.

> Of the shares listed, Malcolm has stakes in BP, Aviva, GlaxoSmithKline and Lloyds.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

lotontech 01 Jun 2010 , 4:12pm

Good article.

My own studies -- I don't remember if I sent you the book, Malcolm -- demonstrated to my own satisfaction how foolish (small 'f') it is to buy and hold a stock purely on the basis of a high dividend yield. And possibly the same is true of screening purely on low P/E.

By all means screen stocks for favourable fundamentals if you wish, but DON'T hold on to them unconditionally and DO have some downside protection in the form of a...

BarrenFluffit 01 Jun 2010 , 4:34pm

Interesting article particularly to passive investing higher yield funds.

rober00 01 Jun 2010 , 4:49pm

Good point lotontech, I hold several of these and have been in and out dynamically on occasion in some of them where it was appropriate.

This has been to my advantage in total return terms and oh yes, I DID NOT use protection in the form of a... to arrive at my decision.



Sidekicker101 01 Jun 2010 , 6:08pm

What is the average of those compared to the FTSE?
We had a post on this recently showing how in the last 10 years a HYP had outperformed a tracker ...

Also, your list has a lot of banks

Tortoise1000 01 Jun 2010 , 6:15pm

So, how about producing a list of the companies that now have a historic yield in excess of one standard deviation above the mean?

NeilW 01 Jun 2010 , 7:07pm

Come on now you have to be very careful of taking a single spreadsheet at the height of the biggest froth market of all time as indicative of anything.

Netherwood 02 Jun 2010 , 12:50pm

It is worth reflecting on what investing is all about. assessing the Discounted earnings of a business over its life time. Then take a wopping margin of safety. Dividends can be cut on a whim. Think about whether you would be happy to buy the whole business. This is how Buffett does it

biosh 02 Jun 2010 , 2:05pm

"So, how about producing a list of the companies that now have a historic yield in excess of one standard deviation above the mean?"

This is just the top 15% of yields - easily identified from the FT pages.

"more than 1 sd above the mean" is a confusing way of saying "the top 15%" as it is actually just a definition for the top 15%.

curedum 02 Jun 2010 , 2:13pm

As investment fund managers know, you can manipulate results by carefully choosing time periods and adjusting exclusions. You would have to compare returns over 3, 5 and 10 years (at least) before reaching conclusions. For example the list above has six banks and three insurers, just before the greatest financial crisis in decades - not an ordinary period in the markets.

drfuzz 02 Jun 2010 , 6:37pm

Good, interesting article, but slightly flawed.
It would have been useful to have a comparison to FTSE 100. According to my estimates, FTSE fell 20-25% during the period. That puts some perspective on the other figures.
The weighting towards financials is very heavy as already pointed out. Strip out financials and all shares except for DSG have performed more or less in line with the market (and you could see DSG's problems coming at the time!). Plus the shares have received high dividends during that period.
Your bottom line is valid though; selecting on yield alone might not be the best strategy!

elephant888 02 Jun 2010 , 7:43pm

@biosh

> "more than 1 sd above the mean" is a confusing way of saying "the top 15%" as it is actually just a definition for the top 15%.

Rather depends on the distribution! eg consider a bath-tub distribution...

Brockasaurus 03 Jun 2010 , 11:50am

Looking at your list, the lesson appears to be: "beware financials!"

I have not checked this but I'd wager that financial stocks have more ways than most to implode.

mcturra2000 13 Jun 2010 , 6:17pm

Interesting article, and useful for reminding us that just going for yield isn't the best strategy.

As others have pointed out, the list is heavily laden with banks, so it's not terribly surprising that that it paints a possibly misleading picture of a consistent trend.

As for BP, well, who could have predicted that?

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