What Investors Need to Know About High-Yield Stocks

If you're like most people, you could use more income. With U.S. salary and wage growth continuing to barely outpace inflation, it's prudent to look for ways to augment your paychecks.

One sensible way to do that is by investing in dividend-paying stocks. First, dividends are generally taxed at a lower level than your wages. For qualified dividends (which most of yours are likely to be), the tax rate tops out at 20%, while the marginal tax rates on added wages can run as high as 39.6%.

Second, dividend stocks are relatively attractive in the current low-yield interest rate environment. Right now, the 10-year U.S. Treasury bond yields 2.4% and the average 5-year certificate of deposit pays 1.5%, while the broader S&P 500 currently has a dividend yield of 1.9%. 

Third, in recent history, dividend stocks have the best track record of outperforming inflation. Over the last year, the S&P 500 has increased its cumulative dividend payout by 6.9%, more than double the pace of wage increases. Many fixed-income products have higher current yields but do not increase their annual payouts, and inflation can eat into income-based returns.

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Proceed with caution in high-yield investing

One of the most basic techniques of income investing is to purchase high-yielding dividend stocks. The dividend yield is simply the ratio of the current price per share of a company to the dividends per share paid out over the past 12 months. The logic behind buying high-yield stocks is simple: As a shareholder, you are entitled to the dividend, so paying the lowest cost for the largest relative dividends (i.e., the highest yields) would seem to be preferable.

However, this may be one of the more dangerous ideas in investing. There are a few significant risks with using dividend yield as your primary criterion for making an investment decision. While it's smart to evaluate a company's past dividend payouts, investors should put more emphasis on how probable it is that the company will be able to continue them.

When a large segment of investors become skeptical of a company's prospects due to industry changes, poor management, or economic conditions, they will sell their shares of the company. This depresses the stock price, which has the perverse effect of making the dividend yield more attractive in the short run. This is referred to as a yield trap: If  (or more likely) when the company eventually cuts its dividend payout, the factor that induced you to buy it will be gone. Recently, this was the case with General Electric, which cut its dividend from $0.96 per share to $0.48 per share, a 50% decrease.

That said, high-yielding stocks of companies that can turn things around often outperform the greater stock market as investors recognize them to be safer prospects with outsize yields.

A starting point for high-yielding investing

A mistake many investors make when evaluating a company's ability to pay its dividend is using the common dividend payout ratio (dividends per share/net income per share) and the dividend yield as their only evaluative metrics. However, dividends are paid from cash generation, which can vastly differ from accounting earnings in both the short and long terms. The main discrepancy between net income, (aka, accounting earnings) and cash-flow generation is depreciation, as this is not a cash expense but rather a method of expensing costs of long-term assets like factories or buildings.

A much better measure of a company's ability to continue to pay (or raise) its dividend is the free-cash-flow payout ratio, which replaces net income with the free-cash flow (cash from operations minus capital expenditures). This measures the true cash the company is generating versus what it's paying out to shareholders. Additionally, it's a good idea to pay attention to a company's net cash position, as companies with a lot of cash can continue to pay their dividends even the event of temporary operational weaknesses.

Top 10 highest-yielding companies in the S&P 500

Data as of Nov. 13, 2017

CenturyLink

Within the S&P 500, the current top-yielding stock is CenturyLink. The company's core businesses are in the competitive broadband and telecommunications industries, and it owns a lot of assets in the declining wireline subsegment. CenturyLink does not have the scale of larger competitors like AT&T, Charter Communications, Comcast, and Verizon. Investors continue to have low expectations about its ability to continue servicing the dividend.

Recently, the company completed its acquisition of Level 3 Communications, a business and government focused service provider, which should give CenturyLink significant scale that it can use to focus on the enterprise. Management has made defending its dividend a priority, as CEO Glen Post III noted:

CenturyLink's management and board of directors see our quarterly cash dividend as an important part of our value proposition for shareholders. Upon completion of the Level 3 acquisition, we anticipate generating nearly a billion dollars in cash synergies, as well as significant cash tax savings from the accelerated recognition of Level 3's net operating losses. These cash savings, along with our focus on profitable growth, are expected to drive increasing free cash flow per share, enhance our financial flexibility and improve our dividend payout ratio.

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Macy's

Like CenturyLink, Macy's is also facing questions about its business model. The department store chain's stock fell more than 50% over the last year, and many investors are quite skeptical of how the business model of traditional retail with fare under intense competition from e-commerce players like Amazon. In the last two years, more than 20 retailers have filed for bankruptcy protection, including Sports Authority, Toys R' Us, and Payless ShoeSource. 

Many analysts have tried to predict which chain with be next to drop, but my colleague Adam Levine-Weinberg feels it won't be Macy's. He argues that its cash flow can support its dividend, at least in the near term; free cash flow is roughly double what the company paid out in dividends last year. The company is in the midst of restructuring the business, selling less-productive assets to pay down debt and increase operating margins. If the company executes on those plans successfully, investors could strongly benefit, given the current exceedingly bearish outlook the market has on it.

Seagate Technology

In a recurring theme, the third highest-yielding stock in the S&P 500 also faces questions related to its business model. Seagate Technology is a large manufacturer of hard disk drives (HDDs). However, most computers now use solid-state drives (SSDs) for storage, as their performance is better and HDD's cost advantage continues to shrink. Last year, Seagate's primary contender Western Digital acquired SanDisk to pivot to SSD manufacturing, while Seagate remains mostly tethered to HDD technology.

Seagate's shares rallied after it reported third-quarter earnings. Sales fell 6%, but the company has been cutting its expenses as well, which helped it produce earnings per share growth. However, the company reported a year-over-year free cash flow decline of 75%, which is a metric long-term income investors should strongly consider before buying shares for the dividend.

Look before you leap

Everybody wants more income, but it's important to avoid taking unwise risks. Looking for high dividend yields is a good starting point, but on its own, its a poor strategy for picking stocks to deliver long-term income. Do your proper due diligence, and evaluate a company's cash flow, its economic environment, and the probability of a dividend cut before you buy its shares.