High dividends deserve attention

By David McEwen

Monday 26th August 2002

US companies that have been hit by scandal recently - Enron, WorldCom and the rest - followed a common, destructive path. They were obsessed with growth in their profits and share price, they manipulated their accounts and they paid out the minimum dividends they could get away with.

The reason they were so miserly is that dividends require cash - and you cannot invent cash you do not possess.

Companies that generate cash to pay good dividends are far less susceptible to accounting trickery. That is one reason investors globally are taking more interest in companies with attractive dividend yields. Another is the defensive nature of high yielding shares, which are becoming more attractive as markets look more uncertain.

The share price of a high yielding share is underpinned by the value of its dividend. As long as the dividend payout is sustained, the price can't fall too far because the yield rises, attracting investors. Talk about high yielding shares is suddenly becoming more common. And it isn't just your traditional income seeking investor, approaching retirement that's taking an interest.

Techniques for finding high yielding shares are being debated and books like Beating the Dow, written some years ago by Michael O'Higgins, are being sought out.

The book reveals Higgins' method of buying blue chips when they are out of favour and offering historically high yields.

He back-tested his theory and found that this technique offered one of few ways that small investors without time on their hands, or huge amounts of expertise, can beat the biggest fund managers over time. The method works best, of course, at times of great market uncertainty, when prices are falling and yields rising.

Scan the sharemarket pages you can find at least 20 New Zealand companies that could be classified as high yield investments, delivering a dividend of 7% or more.

However, the high yield on some shares can be highly misleading, for two reason: The yield is determined from historic payouts, which might prove to have been erratic in the past, or not be sustainable if earnings are heading down.

Also, sometimes a company is tempted to pay out more than is prudent in order to keep shareholders happy, or to satisfy a majority shareholder. Some major New Zealand companies have been damaged in this way.

So, once you have identified some promising high yielding shares, you should run them through a checklist to determine whether they capable of keeping up their dividend payout. Doing so will weed out at least half of those appearing on the original list.

Here are some key questions to ask:

- Have earnings per share grown in five of the last six years?

- Has the company increased or maintained its dividend in five of the past six years?

- Is the dividend yield at least 50% higher than the risk free rate you can get from government stock?

- Has the company produced positive cash flow in at least five of the past six years?

- Does it have a low ratio of debt to equity, compared with others in the same industry?

- Is the company vulnerable to a fall in earnings because, for example, it is a minor player in an increasingly competitive industry, or it operates in a cyclical industry?

If the answer is yes for the first five questions, and no for the last, chances are you have found a quality yield investment.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz

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