Why Cheap High Yield Dividend Stocks Are A Losing Bet

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Value investing remains one of the most consistent strategies available for small investors, with strategies varying from cheap high yield dividend stocks to low price-to-earnings, and many more in between. 

One popular strategy for value investors has been using dividend yield as a valuation metric. In fact, it is one of the oldest methods of stock valuation!

So what is a dividend yield and why do they care so much about it?

The dividend yield is a percentage that allows investors to quickly see what the dividend-only return of a stock would be if they invest in it. 

Its formula is the company’s annual dividend divided by the share price. The number you get in return is the amount an investor can expect to receive as a percentage of the company’s share price. 

For example: A stock selling for $10 that pays a $1 annual dividend has a 10% dividend yield. If the price falls to $5, then it becomes a 20% dividend yield. 

Investing based on dividend was popular in the early 20th century when most people owned stock for their dividend, not for stock price appreciation. Nowadays, it is also popular amongst defensive investors looking to generate a steady side income from their portfolio.

Sounds perfect right? Get a steady income and capital appreciation by investing in cheap stocks with high dividend yield. However, things are a little more complicated than that. There's actually a much better performing strategy for income investors — and no, it's not dividend growth investing. 

Cheap High Yield Dividend Stocks: The Original Value Investing Formula?

As stated before, investing in cheap high yield dividend stocks is one of the oldest styles of investing. During the late 1800s and early 1900s, stock ownership was predominantly an income source. Back then, the largest companies all provided dividends as a sign of financial health. 

Buying a stock specifically for value appreciation was seen as a speculative fool’s errand.

Today, investment in dividend-paying stock has evolved with the times. Now, many investors in this school invest exclusively in cheap high yield dividend stocks — that is, stocks that the investor has decided to be fairly valued, with an added filter of high dividend yields. 

The dividend yield formula is the company’s annual dividend divided by the share price. The number you get in return is the amount an investor can expect to receive as a percentage of the company’s share price. 

For example: A stock selling for $10 that pays a $1 annual dividend has a 10% dividend yield. If the price falls to $5, then it becomes a 20% dividend yield. 

As you can see, two things impact the dividend yield: The annual dividend and the share price. I’ll return to that point later. 

This naturally provides some benefits to the investor. It is a relatively straightforward and simple investing strategy that requires little research, has straightforward logic and can be done completely mechanically. 

It is even easier to find stock picks for those that only invest in “Dividend Aristocrats” — companies that have consistently raised their dividend for 25 years or more — because there are so few of them.

The Dividend Margin of Safety

Investing in cheap high yield dividend stocks provides investors with returns in two forms — stock appreciation as the stock reaches its fair value from its undervalued price and the dividend income an investor receives while he waits for this to happen. 

This dividend stream can come in handy as an investor can do whatever they want with this income while their cash is parked in their stock picks. They could choose to reinvest it or pull it out of their brokerage account.

The reason why looking at a dividend yield — and companies that consistently provide a dividend — works so well with other value investing principles is that it could add to a company’s margin of safety. In order for a company to provide its investors with a dividend, the logic goes that it needs a healthy balance sheet and enough free cash to actually pay out. 

If a company can pay out a higher dividend yield compared to other similar companies in its sector, this can be a sign that the company is more financially healthy than its competition.

Finally, investing in cheap high yield dividend stocks provides an extra buffer of downside protection. Not only have you purchased the company cheaply, but also during a downturn, investors can still receive a dividend.

This means that even if the value of your investment has dropped, you are still receiving cash, cushioning the blow of the drop.

Is Investing in Cheap High Yield Dividend Stock Too Good to Be True?

While there are benefits to investing in cheap high yield dividend stocks, there are also risks associated with this style of value investing, which I want to shed a light on.

One of the largest issues is that investors who choose this strategy rely on the dividend yield, which in itself can be misleading. You see, the dividend yield is a product of the company’s annual dividend divided by the stock’s price. This means two factors lead to a higher dividend yield: a larger annual dividend or a lower stock price. 

The problem is, if you only look at dividends, you may not know which one of these factors is responsible for the high dividend yield. It could be that the company has had a terrible earnings season, has a very bleak outlook, and that this has caused its dividend yield to rise. Investors expect its earnings to erode and believe that the dividend is in danger of being cut.

Now, many of you are thinking that a cheap stock might be a good value play — and you are right — but you must also consider the fact that during hard times, many companies will cut their dividends. In most cases for investors that follow a dividend strategy, this is an immediate reason to remove a stock from your portfolio. 

With that, not only could you be missing out on a great value play, but this additional turnover of stocks in your portfolio would only add to your costs — be it trading costs, slippage, or simply the cost to get into a new stock!

Finally, there are funds and ETFs that also follow this popular strategy. Oftentimes, this leads to companies such as the dividend aristocrats to being perennially overvalued. This leaves value investors with fewer choices in finding cheap high yield dividend stocks.

Is There a Better Way?

There is sound logic in using the dividend yield as a measure of value, but as shown, it is just too volatile to be used as the primary basis for your investing decisions. 

What I prefer is a strategy that has outperformed the markets by a huge margin since the 1930s. It’s a strategy that does not rely on hoping a stock maintains its dividends or sustains enough cash flow to support its dividend yield. 

This strategy was Benjamin Graham’s Net Current Asset Value (NCAV) system. The beauty of this investment strategy is that it is grounded in simple, sound logic. 

Using Graham's NCAV strategy, we measure a company’s value by taking all of its current assets and subtracting all of its liabilities, along with any debt not included in current liabilities. Any company trading at least 67% of its NCAV per share warrants further research. 

The goal with net net investing is to reach the most conservative valuation possible for a stock. Taking the worst case scenario for a company’s valuation guarantees us the best margin of safety. 

This valuation is based on what Graham called “liquidation value” — the price a company would fetch if it were sold today. This measure of value is more consistent and less volatile than looking at a company’s dividend yield. 

Additionally, at Net Net Hunter we have, through research and study, added seven core criteria to further narrow down our picks to only the highest quality net nets. We look for things such as low debt and a catalyst among other factors — all in an effort to ensure the widest margin of safety possible. 

Some of these criteria overlap with criteria that would make a good cheap high yield dividend stock. For example, net net stocks with a large current account surplus are a more attractive pick, just as high quality dividend stocks need large current accounts for their dividends. 

Finally, just because a stock is a cheap net net does not mean it can’t pay a dividend! 

On the contrary, there are international net nets paying healthy dividends. And, as opposed to simple cheap high yield dividend stocks, net nets with high dividend yields often have high yield because they are undervalued on a net current asset value basis, not because its earnings are eroding and its dividend is at risk of being cut, as mentioned in the high yield dividend trap!

What’s an Investor to Do?

I believe that net net investing is the best option for any value investor, conservative or aggressive. Why?

When you invest in net nets properly, you stack the deck in your favour. There is far more downside protection in current assets and low debt than a strategy that focuses on a yield that can easily change from quarter to quarter, affecting the underlying investment. 

For those of you still desperate for an income from their stock portfolio, let me pose this question to you: 

You can choose from a portfolio of stocks, mainly American, concentrated in a few sectors, with an average annual return of 14%, including an average 4% dividend yield. Or, you could own an international portfolio of net nets, which James Montier’s study showed would provide an average return of 35% per year over the course of 22 years.

The difference in outperformance of the net net stocks annually will more than make up for any possible dividend stream you may think you are foregoing. 

You decide what is the more valuable strategy.

To get a free net net stock checklist, click here. Start putting together your high quality, high potential, net net stock investing strategy right now! 

Article Author: Isaac Aydelman

Article image (Creative Commons) by Theo Crazzolara edited by Net Net Hunter.