Central banks the world over are buying high-quality bonds, thereby removing them from the market and forcing savers to find alternative strategies to meet their income needs. In this environment of financial repression and near-zero interest rates, dividend-yield (or equity income) investing has become increasingly popular. Investors are understandably reallocating their portfolios from lower yielding bonds to higher yielding equities. But in selecting equities with a high dividend yield, investors should be aware of the risk of concentrating their portfolios in low-quality companies.
In 1970, George Akerlof published “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” an article for which he won the Nobel Prize. In the article, he explains the problem of asymmetric information by examining the market for used cars: some used cars are “cherries” and others are “lemons.” The rub, however, is that the buyer cannot distinguish between them. Only the seller knows if the used car is a cherry or a lemon. Afraid of buying a lemon, the buyer demands a discount from a would-be cherry’s price, and the seller –Â if knowingly selling a cherry –Â will refuse to deal at the discounted price. Without a meeting of the minds, the seller will not receive a fair price and is discouraged, as are other owners of cherries, from even offering them for sale. As a result, the market for used cars contains a disproportionate amount of lemons.
Akerlof’s observation about used cars can help us understand why more information improves purchasing decisions, and not just for used cars. As when buying a used car, buying bargain equities can produce nasty surprises. Measuring the quality (reducing our information asymmetry) of the companies whose equities we are considering adding to our portfolio can improve our investment returns.
Dividend-yield investing
Investing to earn a high dividend yield is a venerable and sound strategy. Because most companies choose to pay a steady dividend to their shareholders, dividends –Â their frequency and amount –Â are persistent and much less volatile than equity prices. Investors can thus use the much higher volatility of equity prices as an opportunity to buy future dividends quite cheaply. Further, dividend-yield investing allows investors to distinguish income from principal: investors can spend dividends and leave principal intact. The income sustainability strategy works better, however, if the companies whose equities investors buy are not lemons.
Table 1 compares a portfolio composed of the 200 highest yielding U.S. equities selected from the 1,000 largest companies by market capitalization, rebalanced annually, with a portfolio of the 1,000 largest U.S. equities. Both portfolios are capitalization weighted.
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The high-yield portfolio provides a much higher realized dividend yield (5.6% vs. 2.9%) and total return (12.3% vs. 10.2%) with lower volatility (14.2% vs. 14.8%). The higher return is no surprise because yield is measured as the ratio of dividend to price and is thus a direct measure of value. Cheap equities (i.e., equities with a relatively higher yield, or higher dividend to price) have historically, on average, outperformed expensive equities. Lower volatility, however, is a pleasant surprise.
Although the high-yield portfolio delivered both higher dividend yield and total return, it also had a higher percentage of delisted companies1 and slower dividend growth. So if not every cheap dividend (i.e., the dividend paid by a cheap equity) is a bargain, can we avoid the lemons? Yes! For dividend-yield investors, three characteristics help us judge the quality of the companies that offer high dividend yields: profitability, distress, and accounting red flags that can indicate poor management, sometimes extending to fraud.
Profitability
Some cheap dividends belong to companies with poor growth prospects, rather like used car lemons that are always in and out of the auto repair shop. To avoid these lemons, we need a reliable method for assessing a company’s prospects for growth. An intuitive and effective indicator of future growth is current profitability, as measured by return on assets (ROA).
The story of Blockbuster Video Entertainment, Inc., illustrates the risk of investing in companies with a high dividend yield, but poor profitability. Blockbuster, in the business of renting movies (on VCR cassettes and later DVDs) from its stores, was a profitable business from the late 1980s to the mid-2000s. But with the arrival of broadband and on-demand access to movies through cable and satellite, its business model became obsolete. Blockbuster’s profits suffered, and in 2010 the company filed for bankruptcy and was acquired a year later by Dish Network.
In Table 2, we report the same six metrics for the 200 highest yielding equities from Table 1, dividing the portfolio into two groups: the top 100 equities in terms of profitability (as measured by ROA2), and the remaining 100. We call the first group the High-Yield, High-Profitability 100 and the second group the High-Yield, Low-Profitability 100.
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The high-yield, high-profitability portfolio generated higher total return (12.8% vs. 12.3%) with lower volatility (13.7% vs. 15.4%) and higher subsequent five-year dividend growth (18.6% vs. 10.5%). The higher return is not a function of higher dividend distributions, but of a faster rate of company growth. Profitable companies possess internally generated resources to fund growth opportunities and sustain dividend distributions. Cheaply priced dividends of companies with low ROA are like the lemons that require frequent and expensive trips to the repair shop.
Distress
Like a used car’s disrepair following many miles of aggressive driving, some high-yield companies fall prey to distress. Perhaps the simplest and most effective indicator of distress risk is the debt coverage ratio (DCR). DCR is the ratio of a company’s earnings available to make debt payments to the company’s near-term debt obligations. It measures a company’s debt-servicing capacity. Examples of companies with a high dividend yield and a low DCR that were subsequently delisted or filed for bankruptcy include General Motors, Lehman Brothers, Washington Mutual and Fannie Mae.
In Table 3, we divide the 200 highest yielding equities from Table 1 into two groups: the 100 equities with the highest distress risk (as measured by DCR), and the remaining 100. The first group is the High-Yield, Low-Distress 100 and the second group is the High-Yield, High-Distress 100.
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