Digging Deeper to Avoid Yield Traps

 Executive Summary

  • The chase for dividend yield has created bloated valuations in some sectors.
  • Free cash flow yield can provide insight into a company’s strength.
  • Paying out too high a dividend can limit a company’s path forward.

The hunt for dividends has shown little sign of slowing. Through the first nine months of the year, the top 30% of names based on yield in the S&P 500 outperformed the remaining stocks by more than 900 basis points on average. Other major indices have seen similar results as the struggle to replace income formerly generated by bonds continues.

Markets Driven by Yield

Heartland Advisors Value Investing Market Perspective Yield Chart

Source: FactSet Research Systems Inc., Heartland Advisors, Inc., Standard & Poor's, and Russell® 1/4/2016 to 9/30/2016
Deciles exclude non-dividend payers and are organized by dividend yield with 1 representing the highest payers and 10 representing the lowest payers. Past performance does not guarantee future results.

The upward climb coincides with nearly eight years of historically low yields for fixed income. Adding to the effect is the heightened importance placed on low-volatility/high-momentum stocks. The combination creates a feedback loop where stocks are bid up for their yield and then additional buyers enter because shares have performed well and price movements are stable.

A Widespread Issue

Utilities and Real Estate Investment Trusts (REITs) top the list of sectors where the pursuit of income has produced frothy valuations. Despite a third-quarter pullback in power companies, the sector in the S&P 500 still trades at 17.1x estimated 2017 earnings—well above its 20-year average of 13.6. Real estate is at similar levels. While the two areas are the most obvious, the phenomenon is widespread.

Yielding to Reason

Many of our portfolios have a dividend focus, including our Mid Cap Value Strategy, however, we believe a process that focuses solely on the ratio of payments to share price is shortsighted and could be costly over the long term. Instead, we look at current dividend rates as a single piece of a bigger picture including free cash flow yield and payout ratio. Using these two measures is consistent with our long-term value focus.

Even the most attractive dividend rates will lose their appeal if they become unsustainable. To that end, we look at how much income a business generates after paying its expenses as an indicator of whether cash distributions will endure. If a company’s cash flow is shrinking, it likely won’t be able to continue to pay investors at current levels. However, a business that generates increasing profits is better positioned to maintain or expand dividends.

Too Much of a Good Thing?

While dividends can be a welcomed aspect of total return, as long-term investors we want management to be prudent about the amount of income it returns to shareholders. We look to payout ratios to help gauge whether a business is being too aggressive in distributing cash. Put simply, businesses that are paying out a relatively small portion to shareholders have greater flexibility to increase dividends in the future or could use retained cash to invest in expansion or pay down debt.

A Closer Look Exposes Big Differences

The following example of two dividend-paying names illustrates how looking beyond dividend yield is integral to comparing potential investments. We’ve chosen these businesses to show how free cash flow yield and payout ratio can help uncover the more compelling opportunity when looking for high yielding equities.

Motorcycle manufacturer Harley-Davidson, Inc. (HOG)—a holding in our mid-cap portfolio—controls more than 50% of the domestic new market and has a strong following in Japan, Canada, and Europe. WEC Energy Group, Inc. (WEC) is a utility operating primarily in Wisconsin and Illinois.

Harley Davidson’s forward dividend rate is $1.39 per share. At a share price of $49.83 on October 14, its forward yield was approximately 2.8%. WEC’s forward dividend rate is $1.98 per share and it was trading at $57.74 on October 14. Therefore, its forward dividend yield was 3.4%. For income hungry investors the dividend rate of the companies may make WEC appear to be the more attractive stock.

Yielding Different Results
  Harley-Davidson, Inc. (HOG) WEC Energy Group, Inc. (WEC)
Share Price $49.83 $57.74
Dividend (2016 estimate) $1.39 $1.98
Earnings Per Share (2016 estimate) $3.87 $2.93
Payout Ratio 36% 68%
Dividend Yield 2.8% 3.4%
Free Cash Flow $848.3 mil. -$168.5 mil.
Free Cash Flow/Share $4.74 -$0.53
Free Cash Flow Yield 9.5% -0.9%


Source: FactSet Research Systems Inc., as of 10/14/2016

However, a look at free cash flow yield makes the case for WEC less clear. During its latest fiscal year, the utility generated a negative $0.53 per share in free cash flow, which translates to a yield of -0.9%. By contrast, the motorcycle manufacturer generated $4.74 per share in cash during its most recent fiscal year, resulting in a yield of 9.5%. The upshot is that Harley is generating cash per share, unlike WEC, and the income can be used to either increase future dividends or used to pay for growth or to reduce debt.

Some may still be tempted to hold the utility due to its recent performance and the sector’s history of relatively stable stock prices.

The ability of both companies to fund growth opportunities and/or increase dividends, we believe, will have an impact on future returns and stability. Harley has a payout ratio of approximately 33%, meaning that 67 cents of each dollar in profit is available for paying down debt, sustaining a dividend during a sales slump or reinvesting to grow the business. By contrast, WEC pays 68% of its net income out in dividends, meaning it has far less room to raise distributions, pay down debt or fund growth.

By digging deeper into the numbers that affect dividend yield, we are able to add an additional layer of evaluation when determining whether a company offers a compelling opportunity. We use this analysis alongside our 10 Principles of Value Investing™ as an attempt to ensure we don’t overpay for businesses that offer attractive dividend yields.
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Presenter

Heartland Advisors Value Investing Portfolio Manager Colin McWey

Colin McWey

McWey, CFA, is Vice President and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He has 15 years of industry experience, 8 at Heartland.

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Past performance does not guarantee future results.

Investing involves risk, including the potential loss of principal.

There is no guarantee that a particular investment strategy will be successful.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

Dividend-paying stocks cannot eliminate the risk of investment losses. Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

The Mid Cap Value Strategy seeks long-term capital appreciation by investing in mid-size companies as defined by the market capitalization range of the Russell Midcap® Index. This focused portfolio seeks companies with strong underlying business franchises priced at a discount to their intrinsic worth that have temporarily fallen out of favor.

As of 6/30/2017, Heartland Advisors on behalf of its clients held approximately <0.01% and 0.00% of the total shares outstanding of Harley-Davidson, Inc. and WEC Energy Group, Inc., respectively. 

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Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

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