How to choose a good high yield share for the long haul: HYP Part 2

Part One of this series introduced how dividend payments from shares can produce a growing income stream with minimal effort on your part, and certainly no need to frenetically ‘play the markets’ like a demented monkey bashing the bongo drums. (Remember, study after study has proven most share traders fail to beat buy-and-forget tracker funds over the long-term).

Now we’ll consider in detail what makes a particular share an attractive candidate for a portfolio of high yield shares (known as a High Yield Portfolio or HYP). Part Three will outline how to assemble 15-20 such shares that complement each other by drawing their earnings from different industries, and thus avoid you having all your eggs in one basket. Part Four will demonstrate with real examples from the London stock market the construction of such a portfolio.

While we’re consider high yield shares in isolation below, keep in mind that holding only one high yield share (or several in the same sector, such as banking) is far too risky for our purposes: we’ll look at how to reduce the risks of picking a duff share below, but the greater protection comes from the portfolio approach explained in Part Three.

Hunting for dividend payers by yield

So, you’ve a few thousand pounds burning a hole in your pocket (or, I hope, your high interest savings account) earmarked for high yield shares, and you’ve already made sure your financial foundations are solid. How do you choose a share that’ll keep paying good dividends through thick and thin?

First off, never forget there’s no certainties when investing in shares. Prices go up and down, and both your capital (the money you use to buy the shares) and the income (the dividends) can and are sometimes reduced or even wiped out altogether. If you can’t risk losing the money you invest, keep it in a savings account for now.

With that warning out of the way, let’s look at how we can reduce the risks as much as possible.

There are thousands of shares traded on the various London stock markets, with the majority paying a dividend. As discussed in Part One, you can judge the size of the dividend you’ll receive relative to a company’s share price by calculating its dividend yield.

Newspapers such as the Financial Times and online resources like Digital Look do this calculation for you, listing dividend yields alongside other information about a share, but it’s helpful to have some understanding of how the yield is derived, as it gives clues as to the risks you want to avoid when buying high yield shares.

Monevator.com‘s glossary has covered how to calculate dividend yield, and also explained the difference between the historical and forecast yield. Hereafter I assume you’ve read those articles, or already understand the basics of dividend yield. (You’ve don’t? Then rewind and follow those links, then click back!)

For our purposes in constructing a portfolio of decent dividend payers, we want to choose from the highest yielding shares in the market. All other things being equal (which they’re not, but this is a first filter) we would prefer a share with a forecast yield of 5% to one yielding 4%.

It would be simplicity itself to use a tool like an online sharescreener or to carefully study the Financial Times to pick the 20 highest yielders, buy them, and then collect the cheques, and indeed there’s at least one off-the-shelf fund that does just that with the top 50 highest yielders (it also rejigs its holdings periodically).

We’re trying to be a bit smarter. Rather than picking purely mechanically, we want sustainable payers that will give us our dividends through thick and thin. We need to apply a few more filters before making our selection.

Safety first when picking high yielders for the long-term

Because we’re looking to create a long-term buy and hold portfolio of big dividend payers, we want to avoid companies that might go bust or that might cut their dividends in years to come. Personally, I do this by considering four main criteria: Size of Company, Dividend Cover, Debt Levels and the company’s Dividend Growth Record.

Before we consider each in turn, you might ask why should a high yielder cut its dividend or go bust any more than any other share?

It’s important to realise that high yield to an extent reveals the popularity of a share. If the FTSE 100 is yielding 2% overall, and you’ve found a company yielding 4%, then by the metric of dividend yield (which is just one of many measures) the share looks cheap.

However it could be cheap for a good reason.

Analysts and hence other traders might think that the company is going to report a loss, for instance, and subsequently cut its dividend. A very high forecast yield usually indicates a company whose future dividend is in doubt altogether. In some cases, it can indicate a company in real danger of going bust.

Does that worry you? Good, it should – investing in shares is a risky business, whatever the other pundits tell you. Happily, a high-ish dividend yield very often exists for other, less terrifying reasons.

For starters, sectors go in and out of fashion. Sometimes everyone wants to buy mining stocks and so they’re expensive, other times they’re all buying software companies and mining stocks go cheap. The market is meant to be entirely rational, so such quirks should not occur repeatedly – but plenty of historical studies (such as this one by fund manager Tweedy Browne) have shown that a portfolio of higher yielding shares does indeed tend to outperform a portfolio of lower yielding shares over various time periods.

It shouldn’t happen but it has and does. Such has been reward of going against the popular crowd in the past, and although the past doesn’t guarantee the future in investing, there’s little reason to believe the same thing won’t happen going forward. People have been getting carried away with fads and fantasies for millenia, and they’re unlikely to stop just because you’re investing.

Another more mundane reason for a higher yield can be that nobody really expects the share to grow its profits very quickly, and so the company isn’t rated very highly. The profits made by water and energy utility companies, for instance, are closely watched by governments, even in deregulated markets, for the very good reason that those companies are often near-monopoply suppliers of vital provisions.

If shareholders were seen to be getting too rich at customers’ expense, the government would typically cap the price rises the company can pass on to customers, reducing its ability to make greater profits in the future. Utility companies therefore tend to pay out most of their profits as dividends, as other shareholder rewards such as rapid earnings growth and a fast-rising share price aren’t so likely. (They also tend to take on a lot of debt to maximise returns, which we’ll consider below).

In summary, as investors in high yield shares, we don’t care if we’re unfashionable (in fact, we welcome it for the chance to pick up shares more cheaply) and we’re happy to have a few solid if stodgy dividend payers that aren’t expected to shoot the lights out in our portfolio. We want to avoid shares going belly up on us though, and we also want to avoid dividend cutters if at all possible.

Using the four filters to weed out the undesirables

Let’s now run through how the safety critera (Size of Company, Dividend Cover, Debt Levels and the company’s Dividend Growth Record) will help us avoid shares with dodgy dividends.

Size of company
Big blue chip companies are loathe to cut their dividends. (Lloyds TSB bank, for instance, hasn’t cut its dividend for over 100 years, despite calls from all quarters to do so during troubled periods).

We’ll therefore try to pick our shares from the FTSE 100 – the top 100 largest companies by market capitalisation in the UK. Sometimes we’ll need to stray into the upper echelons of the FTSE 350 for the sake of diversifying our portfolio, but even then we’ll stick to the larger companies.

Dividend cover
A company is legally only allowed to pay a dividend out of its earnings (i.e. its profits). Crucially, those earnings don’t actually have to have been made in the current financial year – it can also pay out of earnings which it has retained from previous years.

This flexibility is a good thing, since it enables a company to ride out rough times without cutting its dividend, even at times when its earnings per share are less than the declared dividend per share.

That said, a company that continues to pay more than it earns will eventually run out of money and be forced to cut its dividend. For this reason, it’s best to select companies with adequate earnings to easily pay their dividend. This ability is reflected in its dividend cover, which has been explained in the dividend cover glossary entry here on Monevator.com.

Simply put, a company with a dividend cover of 2, for example, has twice the earnings per share it needs to meet its dividend payments.

We’ll look for shares with a dividend cover of at least 1.5. We may loosen that in a couple of special cases (usually when the share is particularly high yielding but seems fairly safe), but we don’t want to overburden our portfolio with too many risky bets from day one.

Debt levels
A company’s debt (also called its gearing; see the glossary entry on gearing for more details) is another factor I watch for when picking high yield shares. Companies have to pay interest on debt – money that could be spent (or retained to spend) on paying dividends.

There are good reasons why a company may take on debt. If its business is growing at 20% a year and a loan costs it 10% a year, by taking on debt and investing in its operations, it can aim to make money to pay the interest with plenty to spare for shareholders (good) or fancy office furniture and golden handshakes for executives (v. bad).

But debt also increases the risks associated with a share. Debtors must be repaid, and plenty of companies have gone under as a result of the onerous burden of excessive gearing.

I generally look for high yield shares with debt levels under 50%.

With some otherwise promising high yield candidates, such as utility companies, you have to expect much higher levels of debt. These companies make predictable, slowly growing profits, so they take on lots of debt to maximise the return to shareholders. Since our need for water and electricity isn’t going to cease any time soon, they can be pretty confident of making the money required to meet their interest payments on this debt as well as their dividends, and so it is safe to let one or two such highly geared utility companies into a portfolio.

Dividend growth record
Companies with a history of increasing their dividends year on year inspire confidence they’ll do so in the future. You ideally want to look at the track record of dividend payments, and cut out shares with a record of reducing or even skipping dividend payments.

Again, this rule is open to intepretation and fudge factoring. Sometimes good dividend payers will have bad year and cut their dividend. The share price will often fall, maybe to a level that makes its Forecast Yield look tempting again, and on a reasonable dividend cover rating, too, since the new dividend is smaller and easier to pay.

Should you buy it? There are no firm rules – it’d be an easy game if there were – but I’d probably avoid it until it established a few years of steadily increasing payments again. Some companies may be too tempting to ignore.

What if a company has maintained its dividend but not increased it? Here I’m inclined to give the shares the benefit of the doubt. A company that refuses to cut its dividend even in tough times is exactly what we’re looking for. If the company directors are making the right noises about maintaining the dividend until it’s safe to grow it again, I’ll often buy.

To summarize the safety critera
Size of company: Definitely FTSE 350, preferably FTSE 100
Dividend cover: At least 1.5
Debt: Maximum 50%, except for special cases
Dividend growth record: Avoid cutters!

In Part Three we consider the most important element of all in trying to avoid losses in your portfolio – diversification.

Complete series so far:
Grow your income with dividends from high yield shares: HYP Part 1
Choosing a good high yield share for the long haul: HYP Part 2