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By Mike Ross
Investing in stocks offering high dividend yields is attractive to many investors. However, it’s important for investors to be aware of the dangers in selecting stocks with only this reward in mind.
Dividend yield is often one of the first things investors look at when considering an investment in the equity markets. It measures the return an investor receives in dividends each year, relative to the amount of money invested.
For instance, if an investor buys a share for $10, which pays an annual dividend of 50 cents, the investor receives a 5 per cent dividend yield. That looks like a relatively attractive return compared to the 3 per cent they could earn on a standard savings account with the bank.
Yet while dividends are an important component of equity markets, they should not be the basis for any investment. Investors would do far better to focus on developing their understanding of the underlying business they are investing in.
A yield obsession
It’s always nice to get money back from an investment. Yet many investors place too much emphasis on dividend yield, without properly considering factors that can have a much greater impact on their overall return.
Let’s say an investor decides to buy that $10 share, only for the share price to decline to $9.50 in a day or two. In this hypothetical scenario, the investor has lost the equivalent of a whole year’s dividend in only a couple of days. This highlights the danger in comparing an investment in the stock market to a bank deposit, where you are guaranteed to receive your principal back in full.
Dividend yield also has an inverse relationship with price: as the price of the share decreases, the yield increases. If an investor is fixated on dividend yield, then the stock that was originally $10, and yielding 5 per cent, appears even more attractive at $9.50.
The problem with this interpretation is that there’s often a good reason why that stock has declined in value. Perhaps the business is underperforming, or maybe investors see significant headwinds facing its industry.
If the listed company is heading for tough times, then a drop in the value of their shares is not the only thing the yield-chasing investor risks. The company could also decide to preserve cash by reducing or cutting its dividend. Say goodbye to that dividend yield investment thesis!
Focus on the fundamentals
The bottom line is that it’s essential for investors to look beyond the dividend yield and consider the prospects of the business paying them the dividend. It’s important to recognise that when you invest in the stock market you’re buying ownership in real businesses that are affected by a wide range of factors.
The dangers of investing in stocks for yield are also particularly acute in the current economic climate. Record-low interest rates have forced investors globally to reconsider where they park their cash, and the stock market has been a popular destination.
The cost of increasing yields
We might assume that the dangers of investing for dividend yield are clear to investors. However, some alarming examples suggest this is not the case.
Take BHP Billiton (BHP), an Australian icon and the largest mining company in the world. Until recently, BHP was enjoying unprecedented demand for its product, driven predominantly by China’s growth.
This led to the company maintaining a progressive dividend policy — that is, to increase or at least maintain the dividend every year. As a result, many investors bought into BHP to receive what appeared to be a reliable, attractive dividend yield.
Although BHP is a top-tier mining company, it’s still in the business of selling commodities, which are highly cyclical and unpredictable. Commodity prices depend on demand, and that’s something that is completely out of BHP’s control.
This is a recipe for disaster. BHP is guaranteeing shareholders a stable cash flow — in the form of dividends — despite its own cash flow and profitability being at the mercy of commodity markets. To make matters worse, BHP’s chairman has in recent weeks said the company could look to fund its dividend with debt. The inherent danger of a cyclical business borrowing from the bank only to pay out the same money to shareholders is obvious.
Piecing it together
Based on BHP’s Australian share price at the end of 2014, the company was trading on a dividend yield of 6.3 per cent, a reasonably attractive return in a low-interest-rate world. So how would an investor buying into BHP on the basis of this yield idea have fared?
BHP shares are down 31 per cent year-to-date (as at November 2015), significantly underperforming the broader Australian market, which is down about
5 per cent over the same period. Meanwhile, its dividend yield has increased to more than 7 per cent.
If industry headwinds persist, then it wouldn't be surprising to see BHP abandon its progressive dividend policy. In fact, some might say it would be irresponsible for it not to. No doubt the yield chasers will be rushing for the exits in such a scenario, licking their wounds and wondering where it all went wrong.
DIVIDEND: The distribution of a portion of a company’s earnings to shareholders.
DIVIDEND YIELD: A financial ratio indicating how much a company pays out in dividends each year in relation to its share price.
HEADWIND: is an aviation term, used as an analogy in business and finance, to describe situations and conditions that make growth more difficult.