Life isn’t perfect and for whatever reason we purchase stocks we shouldn’t have bought, lured in by the high yield, or still hang on to stocks we should have sold. Investor confidence in a company can be sudden and swift.

In the case of TransAlta Corp (TA ) for example (which I dont own) this was pointed out in a recent post by John Heinzl. Management decisions over the sale of the  Sundance coal plants, and the looming threat of a dividend cut, have pummelled the stock price. TA closed at $16.81 per share today, down -20.5% from a recent high of $21.15 per share on February 26th. Back in October, TransAlta was trading over $23 per share. As well as the dividend yield now close to 7%, investors have also been concerned with TransAlta’s high dividend payout ratio at 89.2%, which is high even for a utility it used to be over 100%!

Pengrowth Energy (PGF), a smaller oil and gas producer with a crashing share price (one of my smaller holdings), has left the dividend yield at an unsustainable 9.5%. Like TA the company prefers to measure its payout to investors through cash flow and not EPS.  Regardless of how you slice and dice it, measure cash flow or earnings, or write-off depreciation on oil drilling expenses, the yields of both these companies is likely not sustainable.

Time For a Haircut?

The responsible thing to do of course, from a balance sheet point of view, would be for each of these companies to cut their dividend. Some companies during the financial crisis either froze (i.e. the Canadian Banks) or cut their dividends. In a recent post in the Globe and Mail on TransAlta Corp (TA), David Berman hit the nail on the head when he wrote,

“While markets don’t like the threat of a dividend cut, an actual cut is another matter entirely. During the 2008 and 2009 financial crisis, markets often rewarded companies that cut their dividends – seeing it as a step toward financial responsibility.”

Investors fear dividend cuts, and companies with high dividend yields and declining share prices loathe having to cut their dividends. Companies believe if they cut their dividend, they will lose shareholder confidence. Ironically the opposite is true.  Many investors lose confidence in a company that will resist cutting its dividend at all costs, even if that means accumulating more debt or paying far more in dividends than it earns just to keep the dividend going.  Back in July 2011 I wrote an article for Canadian MoneySaver on this very point in, The Dividend Payout Ratio .

A High Yield Is Not Sustainable

The reality is a high yield is simply not sustainable . whether you measure that payout ratio with EPS or a cash flow measure such as AFFO (Adjusted Funds from Operations). A company can only continue for so long with a high dividend yield, and at some point it will either have to fund the dividend through debt by issuing shares and bonds, or simply cut the dividend. Even for a company with solid cash flow, dividends can’t come out of thin air.

A general rule of thumb I apply for dividend stocks is once the yield rises above 6% you should be concerned .

After all big stable blue-chip companies don’t need to entice investors with high yields, their economic moats, solid earnings, and brand recognition tells the whole story. This is why dividend investors primarily focus on moderate dividend yield (3% to 5.5%), and lower dividend payout ratios.  Dividend investors also focus on companies with low debt. These are the companies that are profitable, pay a portion of their earnings to shareholders, and are able to continue raising their dividends year after year. Although it is tempting to go for high-yield, stable and boring generally wins the day!

What Are the Warning Signs?

But not all dividend stocks are created equal. When smaller capitalization companies distribute high yields, you can usually associate that with declining share prices, poor earnings, higher debt, and even management issues.  Sometimes a declining share price is simply the result of commodity pricing, such as junior oil and gas companies like Pengrowth (PGF). Regardless, larger cap companies can more likely absorb the costs which smaller companies cannot. After all, you are getting a higher yield for a reason.

So when you find a company with a high yield, take a look at the basic fundamentals and watch for these BIG red flags:

• A company with a continuing decline in share price (biggest reason for a high yield).
• A company that has a high DPR (Dividend Payout Ratio) anything over 70% is a red flag!
• Be careful with companies that use Cash Flow instead of Earnings to measure their payout ratios. Many REITs, previous Income Trusts, small caps etc. use Cash Flow instead of EPS. But even if they have a good cash flow measure, that doesn’t mean they are safe.
• A company that has high debt.
• A company with decreasing revenues or declining earnings.
• A company that refuses to cut its dividend at all costs (i.e. YLO).

Pay attention to the warning signs ahead of time, and if there are any red-flags then be a seller rather than a buyer!

The Crashing Share Price

More often than not, a higher yield goes hand in hand with a declining share price. This is usually the result of continued poor earnings, increasing debt, or significant management and company issues. The basic relationship is that when a stock increases in price its dividend yield decreases, and vice versa, when a company share price crashes, its dividend substantially increases.

For example, if you buy oil and gas stock for $10, and the annual dividend per share is .40 cents, then your dividend yield is 4% (.40 dividend by $10). But if the share price crashes to $5 for whatever reason, then the dividend still at .40 cents, means the yield is now 8% (.40 dividend by $5). Since yield, earnings, and cash flow are all related, at some point a higher dividend yield is costing the company additional money when it share price declines.

This is where the biggest problem arises, when companies with a declining share price and high-yield simply refuse to cut their dividend. Some companies will continue to pay the dividend by amassing more debt. Essentially a company in this situation is saying we will keep paying you a dividend even if we can’t afford it .

Good Management Is Willing to Cut the Dividend

Companies usually don’t cut the dividend, even when they should, since they don’t want to lose investor confidence. But there is a point where a company must decide whether it can continue to pay a high dividend yield, fund its dividend through debt, or simply make the cut. Here is the tale of two very different high-yield dividend payers:

Canadian Oil Sands (COS)

Back in December 2010, Canadian Oil Sands (COS) cut the dividend some 60%, after converting from an Income Trust to a corporation. This essentially reduced the dividend yield from over 8.1% to 3.2%. As a result, the share price of COS plunged some 15% as investors dumped their shares.  However, this was a prudent move by COS management. Although the current dividend yield is now risen to  6%, their dividend payout ratio remains well in line around 50%, and they gained back their investor confidence by making the cut (they do have a variable dividend policy).  They demonstrated to shareholders that when a dividend cut was necessary, they would act in the best interests of shareholders instead of continuing an unsustainable dividend.

Yellow Media (YLO)

On the other hand the once darling of the Income Trust world, Yellow Media (YLO) refused to cut the dividend, which was well over 27% at one point,  as their share price crashed throughout 2011 from a high of over $6 per share, to around 6 cents per share. YLO even issued preferred shares and corporate bonds while its yield was excessive and unsustainable which were later graded as junk and then speculative. There were huge bonuses . office closures, layoffs, and lack of overall direction. Eventually YLO eliminated the dividend altogether, but not of its own choosing. But by then it was too late, investors had lost complete confidence in the company and unfortunately their money. The chart of YLO tells the whole story.

The Moral of the Story

Good management (i.e. COS) will cut the dividend early, whereas other companies will continue business as usual (i.e. YLO) until it’s too late. By the time a dividend cut comes for a company like that, it’s game over. There were many warning signs regarding YLO, but the high dividend was a red flag there were other issues at stake.

Readers what do you think? Are you inclined to stay away from higher yield stocks? Do you think a dividend cut is a good thing?

Disclaimer.  I am long on Pengrowth Energy (PGF).