How To Think About Yield

After my previous post on how to think about valuations, this can be considered a “follow-up” post on how to think about yield. Oftentimes, I read about comments in forums or the newspapers which mention how attractive some yields are for certain companies, REITs or business trusts. I also hear of friends, peers and colleagues talking excitedly about high yields and how easy it would be to beat the dismal 0.05% interest rate which DBS is giving on its savings accounts. But what most people may fail to realize or consider is that higher yield is usually accompanied by higher risk – both in terms of the business model of the underlying company/trust and the sustainability of the yield. In other instances, computation of yields is also not conservative as most people make use of past yields to justify purchase decisions by implicitly assuming that yields will carry on being high without adequate consideration for the future. These actions have dangerous implications on one’s portfolio as they may lull an investor into a false sense of security, as he would rely on high yield as a “cushion” or buffer for his investment and expect that he would be able to weather a downturn. The reality is much starker – during economic recessions a myriad of factors may lead to yields being slashed and capital values declining, and that will lead to a double whammy when it comes to an investor trying to beat inflation and also preserve his original investment value.

High Yield from Business Model

There are many instances of high yields to be found in the current stock market environment, with many REITs and Business Trusts advertising yields of 8% to >10%. This in inherently tied to the business model of the underlying assets and the investor has to be astute and take a very keen look at the said business model to ensure that the yield is able to sustain. While many REITs can boast high yields, one should also observe that most are highly leveraged and this could be an issue if a credit crunch of severe downturn hits. To add to this, the risks of a property downturn (leading to a fall in rental rates once rents are due for renewal) could also hit the revenues of many REITs. Yet another factor is the increase in borrowing costs for REITs once their loans are due for roll-over. Perhaps an investor can learn some lessons from the previous credit crunch of 2008-2009 to know that high yields from such securitization of assets is not always guaranteed, and that a fall in capital values of the underlying assets (due to revaluation, no doubt) could also have a devastating effect on the yields being provided by said assets. Not to mention, of course, that capital losses could also offset many years of future yield, as in the case of Babcock and Brown Structured Finance Fund (BBSFF).

High Yield Sustainability from Business Operations

Assuming a steady state business which is of a going concern and which does not involve depreciating assets with finite lives (as in the case of business trusts which hold assets with a finite concession like K-Green Trust), high yield should be viewed from the perspective of ongoing business operations and whether it can be sustained as such. To explain this further (I apologize if it sounds rather lengthy and dry), one should focus on the free-cash-flow generation history of the Company and its consistency to determine if the business can withstand downturns and recessions and still be able to pay out a decent dividend, thus forming the “core” part of the expected yield. As businesses grow and mature over time, they will build up a larger customer base and also forge stronger customer relationships, thus a large part of the revenues and orders may be sustained even if there is a major downturn, unless the Company has an illusory moat or one which cannot be maintained. An ideal business is, of course, one which is able to increase dividend payout ratio as profits trend upward over time, and this demonstrates the classic case of the company with excellent economics and an almost unassailable moat.

In reality, however, most companies do suffer from dips in their earnings, and consequently their cash flows. Hence, in order to portray a realistic picture of the yield from a Company, one should do a 10-year analysis and pick the worst 2-3 years and observe the cash flows during those years. If the Company is still able to generate free cash flows during periods of great economic distress and upheaval, and the business has not suffered long-term and permanent deterioration or setbacks; and if the Company has still maintained its dividend policy throughout that period, then there is a good chance of getting a fairly decent yield which is sustainable. Using this dividend as a benchmark, compute the expected yield based on extremely bearish and pessimistic conditions, and see if it still manages 2-3%. If so, then the Company can be said to be resilient and worth collecting as it may either have superior economic characteristics (e.g. strong, stable moat and repeat customers) or require very little additional capital to function efficiently. Either condition would make the Company suitable for consideration in a value investment portfolio.

Computation of Yield – Pitfalls and Perils

The most common mistake I notice when I speak to investors regarding yield is that they always tend to use last year’s dividend payout as a basis for computing expected yield. This not only assumes that history would always repeat itself, but also makes the mistake of ignoring economic cycles and their (probable) detrimental impact on the business. The perils of computing yield based on historical payouts is that as the business cycle moves, the fortunes of the Company may fluctuate as well. A Company may have good years and bad years, or it could also be a one-off disposal/divestment of an asset or a business division which saw a large inflow of cash and hence the declaration of a special dividend. So investors must be cautious and conservative in their calculation and remove all effects of special dividends, no matter how consistent they seem to be. One example which immediately comes to mind is that of bellweather stock SPH. In its latest FY 2011 results, it declared a final dividend of 9 cents/share and a special dividend of 8 cents/share. In the prior year, there was a final dividend of also 9 cents/share and a special dividend of 11 cents/share. Even though SPH has been paying a special dividend since FY 2002, I feel that an investor still cannot take it for granted that it is a given that this trend will continue, unless he assesses that the business is stable/growing and NOT declining. To be very conservative, one should simply take the interim + final dividend as the total dividend and divide it by the last done share price to compute the expected yield.

Another example in my own stable of companies is Boustead, which had also paid out special dividends in the last two financial years. For FY 2010 (ended March 31, 2010), it paid out a special dividend of 1.5 cents/share while for FY 2011, it paid out a special dividend of 3 cents/share. But core dividend for full-year remains at 4 cents/share for FY 2011 (2 cents interim, 2 cents final) and thus yield should be computed based on this, and not the full 7 cents/share. If special dividend is counted in, it would distort the yield.

Another pitfall often seen is that investors tend to over-estimate company performance and project increasing dividends over the years, even if there is no objective or reasonable basis for doing so. In other words, investors may purchase a Company with the assumption that the yield can either sustain or improve, which may be a fallacious assumption. Margin of safety (for yield) may end up being illusory if the Company suddenly cuts its dividend or announces huge capex to replace old machinery/assets. Business conditions may also force a company to scale back on dividends and divert more cash to fund working capital requirements.

The Illusory Yield "Cushion"

I would say that one of the more dangerous assumptions one can have when investing in companies is to assume that yield can act as a “cushion” should capital values plummet. When speaking to different people, I get the sense that those who invest in assets with high yields are basically assuming that the high yield can somehow compensate for any losses in capital values due to either asset deterioration or a declining market value. While it is true to a certain extent that high yields (high being defined by myself as anything exceeding 7%) can offer some measure of protection against a temporary decline in market prices, it cannot hope to offer a long-term “buffer” against declining business or a major shake-up relating to the underlying asset.

A good and rather recent example would relate to the shipping trusts back in 2008-2009. Yields of >8% were touted back then for FSL Trust, with stable, locked-in charters and a 100%-payout policy (which was to prove not just unsustainable on hindsight, but overly aggressive as well). However, when the underlying asset value (of the ships) began to plunge, many hitherto unknown clauses were triggered (such as loan convenant ratios) and the Trust suffered major hiccups and setbacks. Suffice to say that the touted high yield was unsustainable and the share price drop was massive in order to reflect the new realities after the shipping crash. The permanent and irreversible drop in share price more than offset any quarterly dividends received, and is a prime example of how unprepared one can be for such events and how yield can eventually prove to be both illusory and unsustainable.

Seeking Comfortable, Sustainable Yields

After going through the experience (and heartache) of abruptly plummeting yields, I believe it is better to focus instead on obtaining yields which are lower than the often-touted 8-12%. Good businesses which are generating decent cash flows and maintaining or growing their market share should theoretically be paying about 5-6% yield, with the exception of major market depressing moods which temporarily cause stock prices to plunge (and hence yields to rise sharply).Sustainability should be the focus of an investor seeking yield, rather than going for eye-poppingly “high” yields which can usually be associated with higher risks. Some of these risks may not be readily apparent as the Company or REIT/Trust may not have undergone a baptism of fire and emerged unscathed, thus investors (most with short memories) may not be aware of the potential perils of investing in such securities.

While I do admit there are occasional good deals in which companies can sustain an inordinately high yield, my experience thus far has been one of scepticism and caution. Most companies may seem to pay out high historical yields but the all-important question would be whether these are sustainable moving forward. If not, as an investor I would rather stick to a company with a lower yield (but still higher than inflation) which I feel would be consistent and sustainable over time.

Conclusion

The issue of yields is as thorny as my previous post on valuations, because after all, nothing in the stock market is cast in stone. One has to continually review and analyze the facts on a case-by-case basis and form their own conclusions based on objective data, instead if relying on “preset formulae” when making investment decisions. The best investors have always used a mix of personal experience, business knowledge and theoretical foundations (plus throw in emotional resilience and control) in order to earn consistent returns for themselves without losing money (capital preservation), thus holding true to the mantra of value investing as espoused by Benjamin Graham. Any aspiring value investor out there (including myself) would be doing himself a favour to follow their footsteps and to seek continuous improvement in their methods, techniques and processes.