My entire investment writing career has occurred in the context of the United States thirty-year treasury yielding 4.5% or less, often dramatically less (think 2% to 3%). Similarly, a stock market boom has also accompanied most of the past decade.
This has meant that certificates of deposit have yielded 1-4%, depending on the amount and length of time that the money must be locked up until maturity. Corporate bonds haven’t yielded much higher, unless they had weak earnings or a credible risk of impending bankruptcy. The stock market isn’t much compared to the corporate bond landscape.
And yet, time after time again, income investors desire investments with high starting yields. And yet, I don’t think investors realize how typically unsustainable a high-yielding investment often turns out to be.
Some illustrative data points:
- Of the 122 stocks that traded on the New York Stock Exchange on January 1, 2000 that yielded over 6%, only 6 continued to do so as of 2010 (one year after the Great Recession). These high yields were not sustainable through troubled times as they disappeared during the very next recession.
- Of those same 122 stocks, 74 of them either went bankrupt or engaged in a dilution of greater than 50%. Dividend cuts are tolerable when the business itself is still profitable. But that’s not what happened with the highest yielders. They completely destroyed the value of the shareholder’s investment, either through bankruptcy proceedings or dilution that rendered recovery nearly meaningless.
- Regarding the 122, the average payout ratio at the time of the purchase was 85%. This means that nearly all earnings were being shipped off to shareholders as dividends, permitting little wiggle room for profit fluctuations from the very outset.
- From 2000 through 2015, these investments only delivered compounded annual returns of 3.8%. Considering that dividend payments are taxed when not held in tax shelters, this likely means that no wealth was created net of inflation.
Once an investment yields over 6%, at these prevailing interest rates, there should be a presumption that the payment is not sustainable until you conduct subsequent analysis. And I would have a lot of questions when conducting a fundamental analysis of the investment. Is there an extreme debt burden? Do earnings fluctuate wildly? Does the core business model have a high likelihood of deteriorating—is it presently deteriorating? Are all of the earnings being paid out as dividends—what’s the retention rate at which earnings are generally retained in the industry? How long have these dividend payments been sustained? Is this an accidental high yielder—i.e. is there a high initial dividend yield only because the stock has fallen in value. If so, why?
There is very little, if any, data that supports the proposition that the investments that initially yield a high amount go on to deliver the type of performance that would constitute a long-term success. Instead, it is usually the investments that have a low initial yield and low dividend payout ratio that can support years and years of earnings per share growth coupled with a corresponding increase in the dividend.
And the reason why I say “very little data” rather than “no data” is because there is the Jeremy Siegel study that points out that stocks in the highest quintile of the S&P 500 deliver the best returns over a fifty-year stretch, but there is entirely due to the inclusion of the old Philip Morris. If you don’t include America’s largest tobacco manufacturer, then the data set would state the opposite conclusion (that is, the highest yielding quintile of dividend stocks would become the worst performers). But there is unfairness in saying that because I am removing the best performer from one data set and not doing it to the others.
Anecdotally, I do think that high yield investments invite hucksters and con men that are capital-raising on behalf of a new firm. When many energy sector MLPs became popular in the 2011-2014 range, the partnerships that were trying to become publicly traded or increase their profile often borrowed money to make monthly distributions that were higher than the cash flows that the limited partnership generated. I have no doubt that the mini-bubble would not have happened if MLP yields were initially low and overextension never occurred.
Even in the best of times, high-yielding investments have sustainability because they are in no growth industries and involve the payment of nearly of all the earnings. But, when interest rates are generally low, the risk profile is even worse. There is no track record, as a class, of high-yielding stocks or bonds performing well. The bankrupt/dilution rate is over 50%. I don’t see the appeal in buying a passive investment that yields 8%. The payment won’t be there in 2028.