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's certainly the case with Pier 1 Imports
But there are times where a higher-than-normal yield can be less risky. AmSouth Bancorp
So how can we separate the high-yielding companies from those doomed to cut their dividends, as Eastman Kodak
Avoid these three warning signs
1. 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 without the free cash flow to cover their dividends might sell assets, as Post Properties
2. 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 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 free cash flow 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 the company's adding large amounts of long-term debt for an acquistion or expansion, it may be taking on more than its dividend can handle. Hancock Fabrics
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 AmSouth, a large yield isn't necessarily less secure. The case may be the same with Deluxe
In practice, high-yielding companies like AmSouth can end up being market-beaters. That's exactly what AmSouth has done for subscribers to our Motley Fool Income Investor service. Since its recommendation in September 2003, AmSouth has beaten the S&P 500 by nearly 9 percentage points, with a total return of 39.1%. 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.