Investing is all about trade-offs. Generally speaking, the more certainty there is in an investment, the lower the potential return you can expect from owning it. Within that framework, there is really no such thing as a truly safe investment, as those that are considered such still often lose ground after inflation and taxes are taken into account.
All that said, that trade-off often opens up opportunities for investors looking for income from stocks. For instance, when interest rates rise (as they have been recently), bonds become relatively more attractive sources of income. That tends to drive down the prices of dividend-paying stocks, offering more potential long-term reward for a given investment. As a result, while no investment is truly "safe," there are times when the potential reward from high-yield dividend stocks can justify the risk.
The first question you need to ask when considering a high-yield stock is "why?" Why does the stock trade with a high yield? The answer to that question can go a long way toward helping you understand whether the company might be a decent investment.
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Companies that tend to offer higher-than-average yield
Some companies are more or less required to pay out high dividends. Real estate investment trusts (REITs), for instance, must pay out at least 90% of their income as dividends. This lets them not pay corporate income taxes on the money they pay as dividends, which strongly encourages high payouts.
Similarly, limited partnerships are pass-through entities. This means that their shareholders pay taxes on the income any given partnership earns, regardless of how much the partnership pays them in dividends. Very few people are happy paying taxes on cash they don't actually see, so to attract investors, partnerships also tend to pay out a substantial portion of their income as dividends.
Thanks to those structural reasons, REITs and limited partnerships often offer investors a higher current yield than other stocks, but that doesn't automatically make them "safe." In addition to simply looking at the structure, it's still important to ask that "why?" question.
Like any other stock, REITs and limited partnerships can occasionally get ahead of themselves when it comes to their dividend payments. If the market believes that a dividend cut is coming, it will often punish the company's stock price in advance of that dividend cut, which pushes the company's reported yield higher. As a result, even with REITs and limited partnerships, it's important to look at the company's finances and operations when trying to figure out if its dividend can be sustained.
What to look for in any dividend-paying company
There are three key factors to look at when considering whether a company's dividend may be sustainable:
- Its operations -- how it makes its money.
- Its balance sheet -- how well it is set up to handle itself when things go wrong.
- Its payout ratio -- how much of its cash-generating ability gets consumed by its dividend.
When all three of those factors are healthy, a company's dividend is much more likely to remain covered and paid than when any (or all) of them are dangerously high.
If a company's operations are such that it is likely able to continue making money even in tough economic times, its dividend is much more likely to keep getting paid. After all, a dividend is ultimately only as sustainable as the company's ability to generate cash is. If that goes away, so too does its dividend payment.
Likewise, a company's balance sheet matters because even in a great company, things go wrong. When things go wrong, a business often needs to access cash quickly to try to fix or recover from the problem. From the company's perspective, dividends consume cash, and thus, cutting them becomes a tempting way to free up cash when it's needed elsewhere. A strong balance sheet gives the business alternative sources of cash, which can help it keep its dividend through a temporary rough patch.
Finally, a company's payout ratio determines how much of the cash it generates remains available to it for expansion, versus getting sent to its shareholders as dividends. The lower the payout ratio, the better the company's chances are of both keeping its dividend and being able to increase it over time.
Particularly for REITs and limited partnerships that are involved in capital-intensive business lines, it's important to look at a company's payout ratio when compared to its cash flows, not just its earnings. Due to the accounting treatment of things like depreciation and amortization, those companies are often able to generate far more cash than they report as earnings. As a result, they may still be able to support their growth plans from their own cash flows, even with high earnings payouts.
Put it all together to find higher-yielding stocks that are worth the risk
When you find a company whose structure supports high dividends and whose operations, balance sheet, and payout ratio look good, you just might have found yourself a diamond in the rough. While rare, it is possible to find high-yield stocks where the potential rewards are worth the risks.
If you find one, though, you might want to jump on it quickly. The market doesn't tend to let those businesses remain priced to offer abnormally high yields forever. So once you find one worth owning, it's probably worth buying.
