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.
But there are times where a higher-than-normal yield can be less risky and a lower yield more risky. World Wrestling Entertainment
So how can we separate the high-yielding companies from those doomed to cut their dividends, as retail REIT Mills
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
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
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
This article was originally published on Jan. 13, 2006. It has been updated.
Nathan Parmelee loves dividends, but he doesn't own shares in World Wrestling Entertainment or any of the other companies mentioned. You can view his profile here . The Motley Fool has a disclosure policy.