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 FairpointCommunications (NYSE:FRP), whose yield has been bouncing around the 12% range. Fairpoint makes its living in the declining wireline business. It isn't yet generating enough free cash flow to cover its dividend, and while its long-term debt balances are improving, its ability to cover the interest payments on that debt isn't very impressive. Fairpoint could make it through OK, but it's very much a mixed bag right now, and the high yield accurately reflects that.
But there are times where a higher-than-normal yield can be less risky. Nokia (NYSE:NOK) is a good example of this, with OfficeMax (NYSE:OMX) as the flip side of its coin. Nokia yields 4.0%, while OfficeMax yields 1.9%. Although neither is lighting the world on fire with sales growth, Nokia is able to easily fund its dividend with its earnings. OfficeMax, on the other hand, failed to do so in 2004 and 2005.
So how can we separate the high-yielding companies from those doomed to cut their dividends, as Glenborough Realty Trust (NYSE:GLB) did just last month?
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. Standard Motor Products (NYSE:SMP) is a concern today for this reason. Companies without the free cash flow to cover their dividends might sell assets, or slowly chip away at the cash on their balance sheets. But a dividend not funded by free cash flow is ultimately in danger.
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 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. Wellman (NYSE:WLM) is following this pattern. While Wellman's operating cash flow is improving, its debt load is a real problem. The company is not generating the operating income to fund the interest expense, and it lacks the free cash flow to repay the debt and fund its 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 Nokia, a large yield isn't necessarily less secure. While Nokia is no longer a fast-growing company, and while it faces increased competition, its free cash flow is very strong and its competitive position is still solid. Nokia is certainly strong enough to fund its 4% 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 Nokia can end up being market beaters. That's exactly what Total SA (NYSE:TOT) has done for subscribers to our Motley Fool Income Investor service. Since its recommendation in January 2004, Total has beaten the S&P 500 by nearly 34 percentage points, with a total return of 53.3%. 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.
Nathan Parmelee loves dividends, but he doesn't own shares in Nokia or any of the other companies mentioned. You can view his profile here . The Motley Fool has a disclosure policy.
