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.

Following a year when demand for dividend yield hit a fever pitch, the hunt for dividends has eased somewhat, but many investors remain starved for current income. The focus on companies returning cash to investors coincides with nearly nine 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

Heartland Advisors Value Investing Utilities Sector IconUtilities top the list of sectors where the pursuit of income has produced frothy valuations. The group in the S&P 500 trades at 20.6x estimated 2017 earnings—well above its 20-year average of 14.8.* While the area is 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 $1.46 per share. At a share price of $47.34 on October 31, its forward yield was approximately 3.0%. WEC’s forward dividend rate is $2.08 per share and it was trading at $67.39 on October 31. Therefore, its forward dividend yield was 3.0%. For income hungry investors the dividend rate of the companies may make them equally attractive.
 
Yielding Different Results
  Heartland Advisors Value Investing Consumer Discretionary Sector Icon
Harley-Davidson, Inc.
(HOG)
Heartland Advisors Value Investing Energy Sector Icon
WEC Energy Group, Inc.
(WEC)
Share Price $47.34 $67.39
Dividend (2017 estimate) $1.46 $2.08
Earnings Per Share (2018 estimate) $3.73 $3.28
Payout Ratio 39% 63%
Dividend Yield 3.1% 3.1%
Free Cash Flow $988 mil. $396 mil.
Free Cash Flow/Share $5.79 $1.25
Free Cash Flow Yield 12.2% 1.9%


Source: Bloomberg L.P., as of 10/31/2017

However, a look at free cash flow yield makes the case for WEC less clear. During its latest fiscal year, the utility generated a $1.25 per share in free cash flow, which translates to a yield of 1.9%. By contrast, the motorcycle manufacturer generated $5.79 per share in cash during its most recent fiscal year, resulting in a yield of 12.2%. The upshot is that Harley is generating significantly more cash per share, and the additional 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 39%, meaning that 61 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 63% 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 16 years of industry experience, 9 at Heartland.

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*As of 10/31/17. Estimated 2017 earnings are calculated as weighted median. Dynegy Inc. is excluded from the 20-year average due to a company specific anomaly.

Past performance does not guarantee future results.

Investing involves risk, including the potential loss of principal.

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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 9/30/2018, Heartland Advisors on behalf of its clients held approximately 0.05% and 0.00% of the total shares outstanding of Harley-Davidson, Inc. and WEC Energy Group, Inc., respectively. 

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