Are you looking to build a high yield share portfolio for profitable income? 3 things to watch
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How easy is it to try and set up a high yield stream by investing in high yield stocks?
Some people may just look at a table showing current dividend yields and start with the highest. But that approach can be fraught with danger, for reasons I explain below.
Look for the source of the benefits
One of the reasons why some stocks offer high yields is because their price has been kept low by the City in anticipation of possible budget cuts.
No dividend is guaranteed to last forever. Some cuts come out of the blue completely, or are announced as part of a wider series of unexpected bad news.
But some stocks are giving plenty of hints that their dividends could be cut in the future.
Things to look for include a debt-laden balance sheet, declining profits at the core business, free cash flow less than the cost of equity, and management restructuring the company’s capital allocation policy.
One of those factors alone may not be sufficient to trigger a reduction in benefits or cancellation.
So I’m always looking the source of the company’s dividend payments. How does it make the money it needs to fund its dividend – and does that look likely to last long?
Don’t ignore the share price
One common mistake is to focus only on the reward, not the total return.
When you own a share, the dividends you earn contribute to your overall return – but so do share price movements, be they good or bad.
To illustrate, let’s take a look B&M European Marketing.
B&M’s yield is 7.6% – the higher of the two FTSE 250 and the retail sector.
But over the past five years, B&M’s stock has fallen by 69%. So a stockholder who bought five years ago and sold today will be in the red, despite the high yield.
Stick to businesses you can understand
Even if a business does not generate enough cash from its normal operations to sustain its profits, it may continue to pay them.
For example, it may sell part of its assets to raise cash, which could fund a shareholder payout.
That’s what a viable business can do. In an investment trust it can be especially tempting, as the underlying asset is usually a portfolio of highly liquid assets such as publicly traded stocks.
Such a move can bring rewards today, but at a long-term cost. Due to the complexity of accounting rules, such financial negotiations may not always be obvious to the uneducated.
That’s why, like Warren Buffett, I aim to invest in businesses I understand.
Penny shared Tops Tiles (LSE: TPT) has its share of problems, from a weakening housing market in some areas to disruptions in the supply chain driving up commodity prices. This month it described market conditions as “challenge“.
The high yield – currently 7.8% – could be at risk. Topps has shown itself willing in recent years to cut its dividends when business results require it.
But I like that disciplined approach to finance. And I feel comfortable investing in Topps — and I have no plans to sell — because I feel I understand its business.
Its large depot network and digital offering help it sell one in five tiles purchased across the country. That gives it a solid foundation for long-term financial success.
