Sell in May and walk away. Buy the rumor and sell the news. The trend is your friend. Don't chase high-yielding stocks. All these stock market rules of thumb are meant to save time for investors like you. But often, the companies that offer the best returns get ignored because they violate one of these rules.
As an investor with a focus on dividends, "Don't chase high-yielding stocks" is particularly close to my heart. In theory, a high yield screams high risk. In practice, a high yield can also mean slow growth prospects or a company misunderstood by the market.
A high yield often accurately portrays higher risk; that was certainly the case with Sturm, Ruger & Co. (Nasdaq: RGR ) a few months back when its yield was been bouncing around the 6% range. But Sturm, Ruger makes its living in the firearms business. The company wasn't generating enough free cash flow (FCF) to cover its dividend, and operating earnings were trending down and recently turned negative. The company eventually chose to suspend its dividend temporarily. The high yield existed before then because the market worried (correctly) that the yield wouldn't exist at all going forward.
But there are times where a higher-than-normal yield can be less risky and a lower yield more risky. World Wrestling Entertainment (NYSE: WWE ) is a good example of this, with Pep Boys (NYSE: PBY ) as the flip side of its coin. World Wrestling Entertainment yields 5.5%, while Pep Boys yields 1.8%. Although neither is lighting the world on fire with sales growth, World Wrestling Entertainment is able to easily fund its dividend with its earnings. Pep Boys, on the other hand, failed to do so in 2004 and 2005.
So how can we separate the high-yielding companies from those doomed to cut their dividends, as retail REIT Mills (NYSE: MLS ) did just last month, or suspend them altogether like Sturm, Ruger?
Avoid these three warning signs
1. Inadequate FCF
As you may have guessed, inadequate FCF is the first and most obvious sign of danger. If a company doesn't generate enough of the green stuff from its operations, its dividend is ultimately doomed. Ashland (NYSE: ASH ) is a concern today for this reason. Companies without the FCF to cover their dividends might sell assets or slowly chip away at the cash on their balance sheets. But a dividend not funded by FCF is ultimately in danger.
2. Poor interest coverage ratio
A company's business situation can change quickly, and a couple of quarters of poor FCF aren't always a strong enough indication by themselves. But when other metrics show signs of weakness -- interest coverage ratio, for instance -- investors have reason for concern. Be wary of a rapidly declining interest coverage ratio (earnings before interest and taxes, divided by interest expense). This was the case with Movie Gallery earlier this year, after it completed its acquisition of Hollywood Video. In the first quarter after the acquisition, its FCF was still strong, but its interest coverage ratio fell into negative numbers. The company's dividend, already a paltry 0.94%, was eventually cut entirely. Now Movie Gallery sits on the edge of bankruptcy.
3. Deteriorating balance sheet
While you're watching the interest coverage ratio, be sure to pay attention to the balance sheet. If short-term debt is rising quickly, or if the company is adding large amounts of long-term debt for an acquisition or expansion, it may be taking on more than its dividend can handle. Tarragon (Nasdaq: TARR ) is following this pattern. In addition Tarragon's operating cash flow is declining, which exacerbates the problem. The company lacks the FCF to repay the debt and fund its dividend because so much of its cash flow is tied up in inventory.
Foolish final thoughts
The "stay away from high-yielding stocks" adage has some general value, but it's no substitute for evaluating companies on a case-by-case basis. As we've seen with World Wrestling Entertainment, a large yield isn't necessarily less secure. While World Wrestling Entertainment is no longer a fast-growing company, its FCF is very strong and its competitive position is still solid. The company is certainly strong enough to fund its 5.5% dividend. It's far from a perfect situation, but its slightly high yield points to more immediate danger than I think exists.
In practice, high-yielding companies like World Wrestling Entertainment can end up being market beaters. That's exactly what Diageo (NYSE: DEO ) has done for subscribers to our Motley Fool Income Investor service. Since its recommendation in May 2004, Diageo has beaten the S&P 500 by nearly 14 percentage points, with a total return of 33.2%. If you'd like to learn about other dividend-paying companies that are beating the market, consider a free 30-day trial. You'll get access to Mathew Emmert's more than 50 selections, as well as mid-issue updates and subscriber-specific discussion boards. Click here to learn more. There is no obligation if you're not completely satisfied.
This article was originally published on Jan. 13, 2006. It has been updated.
NathanParmeleeloves dividends, but he doesn't own shares in World Wrestling Entertainment or any of the other companies mentioned. You can view his profilehere. The Motley Fool has a disclosure policy.