As a dividend investor, it is important to differentiate between companies that have high, but possibly volatile yields and those with attractive, but defensible yields.
The first are from those companies that, based on our research, don’t have the capital structure or cash flows to sustain the high payout – commonly known as “yield traps”. Instead, we focus on the second type of dividend yield – those that are defensible in nature, from companies with more resilient cash flows.
Why is the dividend yield high?
An above-market yield can be an attractive attribute, or a red flag. If the stock has come under pressure for reasons that we believe are temporary, this may mean an attractive valuation for a desirable yield. But it may be more of a warning sign that there is risk to the company. This is particularly true at inflection points in the market. Distinguishing between the two is an important part of our job.
Our fundamental research process allows us to look for high dividend yields, while remaining cognizant of the potential for yield traps. We place a tremendous amount of focus on a company’s balance sheet and income statement. We focus on the strength of a firm’s capital structure and look for high levels of free-cash-flow-generation, with stability over a full cycle. As a team, we want to identify companies that have a demonstrated historical bias toward favourable shareholder returns on capital. We want to see a clear track record in this regard.
We use scenario analysis, where appropriate, depending on how cyclical the company is. We also do a sensitivity analysis that incorporates different operating environments for the company in order to stress test our view on the dividend outlook under each environment.
We spend a great deal of time and research understanding a company’s management team and its track record around capital allocation. Time and time again we’ve seen that the management team’s decisions around capital spending can erode value. There are, of course, many examples of value creation as well, so understanding the DNA of a company’s management team has been a pretty powerful tool for us over the years.
Avoiding yield traps with active management
A quantitative, rules-based approach could potentially lead an investor into a yield trap by running a screen on yield and then simply rebalancing the portfolio based on an attractive yield. Because an above-market yield can be a sign of stress and an unsustainable dividend, using this type of approach could lead to a potentially higher-risk-profile investment, which may be contrary to how many equity investors view their dividend value strategy. Using the risk-based approach I’ve outlined above, we strive to avoid yield traps.
I believe that a high-conviction, actively managed approach can provide stable and diversified income for investors, helping them to achieve their unique investment goals.
If you have any questions for Meggan, please leave them in the comment area below.
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