I love nearly everything David Merkel writes, and this is a gem:
The lesson is this: in investing, ignore yield to the greatest extent possible. Focus instead on earning a good return, with safety, and ignoring the payout. It is a little known secret that REITs with the lowest payouts tend to be the best performers over the intermediate-to-long term. It is easier to earn money off of taking equity risk than credit risk.
So, aim for best advantage in investing. Don’t trust yields, but rather look at the underlying economics of the business that you are investing in or lending to. Yes, it is a lot more work, but it is work that you should be doing.
One issue I have with a lot of “Dividend stock investors” is that they do not look at the underlying fundamentals of the company to determine whether yield (and growth of that yield) is sustainable. During the Canadian Income Trust mania (roughly in 2003-2006 before the government shut the whole operation down) you had corporate entities converting into a trust that had absolutely no chance of being able to sustain such distributions. To list all of the offenders in this post would be burdensome, but one of my “favourites” (not that I had ever invested in it, but because they were a local business I paid attention to them) was Hot House Growers Income Trust.
HHG went public in late 2003 after they had a good year. They had distributions which were higher than their net income and they had a significant amount of debt. They began to suffer operationally (too many people were crowding into the business sector) and a couple years later they collapsed and had to be taken over by the surviving entity, Village Farms, which is a penny income trust that will not be giving any yield because their business still has too much debt. They are still publicly traded, although they will likely have to recapitalize again to pay for their debt.
People were buying income trusts in droves simply because they saw the yield and did not consider the return on investment, i.e. whether you would be able to retain the capital in the investment.
My own income trust investments are quite “yieldy”, but their underlying business fundamentals are solid, and generate significant net income (not just cash flows) to sustain the business, after required capital expenditures. Probably the easiest screen you can perform is making sure that net income and cash flows are above the yield (dividend/distribution) rate and ask yourself if the business that is underneath it all can be sustained for the indefinite future.
The other question you should be asking is whether the company has the ability to invest capital that is left over after distributions and debt payment into other capital projects that will continue to give yields that are above the current cost of capital. If so, such companies should not have excessively high payout ratios.
Most dividend stock investors have the right idea, but they don’t do the rigorous research to ensure that they will be paid out without taking a disproportionate risk of capital loss – instead, they just look at the yield/dividend number, and just care that it has gone up historically over a period of many years. This blind-style of investment is akin to driving while looking at the rear view mirror.