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 stock market rules of thumb meant to save you, the investor, time. 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 simply that a company is being misunderstood by the market.
Often a high yield accurately portrays higher risk, as is certainly the case with General Motors
But there are times where a higher than normal yield can be less risky. Take a look at Diageo
So how can we separate the high-yielding companies that allow us to sleep at night, from those doomed to cut their dividends, as Equity Office Properties
Avoid these three warning signs
Inadequate free cash flow
As you may have guessed, inadequate free cash flow 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. Companies with negative free cash flow might sell assets, as ConAgra
(NYSE:CAG)and Post Properties (NYSE:PPS)have done, or slowly chip away at the cash on their balance sheets. But a dividend not funded by free cash flow is ultimately in danger.
Poor interest coverage ratio
A company's business situation can change quickly, and a couple of quarters of poor free cash flow aren't always a strong enough indication by itself. But when other metrics show signs of weakness -- interest coverage ratio, for instance -- there is reason for concern. Be wary of a rapidly declining interest coverage ratio (earnings before interest and taxes/interest expense). This was the case with Movie Gallery
(NASDAQ:MOVI)earlier this year, after it completed its acquisition of Hollywood Video. Its free cash flow was still strong, but its interest coverage ratio fell to negative numbers. The company's dividend was eventually cut entirely, and its yield was a paltry 0.94%.
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 the company's taking on large amounts of long-term debt for an acquistion or expansion, it may be over reaching and taking on more than it can handle -- and still pay a dividend.
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 Diageo, a large yield isn't necessarily less secure.
In practice, high-yielding companies like Diageo can end up being market beaters, which is exactly what Diageo has done for subscribers to our Motley Fool Income Investor service. Since recommended in April 2004, Diageo has beaten the S&P 500 by nearly three percentage points with a total return of 18.8%. If you'd like to learn about more 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.
Nathan Parmelee loves dividends and Diageo products, but he doesn't own shares in Diageo or any of the other companies mentioned. Diageo is an Income Investor recommendation. You can view his profilehere. The Motley Fool has a disclosure policy.