Do Not Overreach for Ultra-High Yielding Stocks

Considering an Equity Income Investment? Do Not Overreach for Ultra-High Yielding Stocks
Investors seeking to diversify their investment income streams often consider dividend-paying stocks as an option. Historically, investing in high-yielding dividend-paying stocks has been an attractive investment strategy both in terms of total return and income generation. However, when seeking income from stocks, it generally has been unwise to simply reach for the highest yields possible. Ultra-high-yielding stocks have had lower average returns and higher volatility than other stocks with above-average yields. We explore this topic in our paper.
 
History
Investors have long been attracted to firms which pay dividends and have attractive yields, and with good reason, as dividend-paying firms have tended to experience above-average stock returns with lower levels of risk over the long-term. The following two charts demonstrate this point. Using data from Professors Fama and French, the charts show performance and volatility for six groups of U.S. stocks: five groups of dividend yield stocks and a “no yield” group of stocks. The data begins in 1927 and goes through 2021 (all available data). In the chart on the left, we see stocks that fall into the top two highest yielding quintiles have performed better over time. The chart on the right shows the performance volatility of these different groups of stocks. Here, we see that the top two quintiles of dividend yield stocks also tend to have low volatility, especially compared to non-yielding stocks.
Source: LIM; Fama, French: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Fama and French data is produced using the CRSP dataset. Charts represent value-weighted returns. Yield is represented with dividend yield from 1/1927-12/2021. Results shown do not reflect our actual client returns. Past performance is no guarantee of future results. Gross performance results may reflect the reinvestment of dividends and other earnings (if any). Dividends = 0; quintiles; Firms with zero dividends are in only the Dividends = 0 portfolio. Portfolios are formed on D/P at the end of each June using NYSE breakpoints. The dividend yield used to form portfolios in June of year “t” is the total dividends paid from July of t-1 to June of t per dollar of equity in June of t. All NYSE, AMEX, and NASDAQ stocks for which we have ME for June of year t, and at least 7 monthly returns (to compute the dividend yield) from July of t-1 to June of t. Fama and French form the portfolios at the end of December each year by sorting on 1 of the 4 ratios and then compute value-weighted returns for the following 12 months.
 
Beware of Ultra-High-Yielders
As we have seen, historically, stocks with the highest yields (quintiles 4 and 5 in the above charts) have generated attractive returns compared to lower-yielding and non-yielding stocks. However, we also observe an interesting phenomenon. Note that in the chart on the left, quintile 5 has offered a bit lower return than quintile 4. Let us explore this point by examining the data in a more granular fashion and splitting the data into ten groups instead of five.
 
Further, let us focus on the 4 highest yielding groups of stocks (decile groups 7-10), with the ultra-high-yielding stocks in decile 10. Again, using data from Fama and French, we see that the ultra-high-yielding stocks performed lower with more volatility than the other high-yield groups.

Source: LIM; Fama, French: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Fama and French data is produced using the CRSP dataset. Charts represent value-weighted returns. Yield is represented with dividend yield from 1/1927-12/2021. Results shown do not reflect our actual client returns. Past performance is no guarantee of future results. Gross performance results may reflect the reinvestment of dividends and other earnings (if any). Dividends = 0; deciles. Firms with zero dividends are in only the Dividends = 0 portfolio. Portfolios are formed on D/P at the end of each June using NYSE breakpoints. The dividend yield used to form portfolios in June of year “t” (e.g. t = 2021) is the total dividends paid from July of t-1 to June of t per dollar of equity in June of t. All NYSE, AMEX, and NASDAQ stocks for which we have ME for June of year t, and at least 7 monthly returns (to compute the dividend yield) from July of t-1 to June of t. Fama and French form the portfolios at the end of December each year by sorting on 1 of the 4 ratios and then compute value-weighted returns for the following 12 months.

Why do ultra-high yielders underperform other high yield stocks?

A natural question that arises from examining this data is “Why do the ultra-high-yielding stocks tend to underperform other high-yielding stocks?” One possible reason is these stocks appear to be less attractive from a fundamental perspective than other stocks with attractive yields. As we see in the table below, ultra-high-yielding stocks have tended to have higher earnings variation and more leverage than the other groups of high yield stocks. In this table, higher numbers denote higher exposure to the fundamental characteristic.

Source: LIM, Factset, Barra, Russell. Each month end from 12/31/1998-12/31/2021, using the Russell 1000 universe of stocks, we group stocks into eleven groups based on dividend yield (one non-yield group and 10 groups of stocks that have a positive dividend yield) and calculate equal-weighted average Barra risk model exposures (using the Barra US Long-Term Model, USE3L) each month from 12/31/1998-12/31/2021 and averaged these monthly numbers through time.
 
It also appears to be the case that investors may not reward ultra-high yielding stocks because they may not believe that the current dividend will persist. That is, investors may believe that the dividends of these ultra-high-yielders might get eliminated in the future. Examining the data, we see that the forward dividend growth rate of these stocks is indeed lower than it is for the other groups and is slightly negative.
 
NOTE: Source: LIM, Factset, Russell. Each month end from 12/31/1998-12/31/2021, using the Russell 1000 universe of stocks, we group stocks into eleven groups based on dividend yield (one non-yield group and 10 groups of stocks that have a positive dividend yield) and calculate an equal-weighted average dividend growth each month from 12/31/1998-12/31/2021 and averaged these monthly numbers through time. Dividend growth is defined as: the (forward 1 quarter dividend – dividend from same quarter one year ago) / dividend from same quarter one year ago.
 
Ultra-High Yield Case Study: Lumen Technologies, Inc.*
To illustrate the danger that may lurk in ultra-high yielding stocks, let us look at the example of Lumen Technologies, Inc. (formerly CenturyLink, Inc.). Throughout 2018, the company consistently paid a quarterly dividend per share of $.54. However, the company also exhibited many characteristics that appeared to lead investors to question the stability of that dividend in the future. For example, as of December 2018, the company was highly indebted, with a Total Debt / Equity ratio of about 182%, had highly variable earnings, and had a dividend payout ratio of over 200%. Amidst this financial backdrop, investors had driven the stock price down relative to the dividend, and by January 2019, the stock’s dividend yield was about 14.0%, making it one of the highest yielders among U.S. large capitalization stocks. In mid-February 2019, the company announced earnings, and in conjunction with that, cut the dividend by 54% to $.25. The stock subsequently performed poorly, finishing the month of February 2019 with a -14.0% return and significantly underperforming the Russell 1000 return of 3.4%. Of course, not every ultra-high yielder underperforms to this extent, but as was the case with Lumen Technologies, ultra-high yielders often have poor financial characteristics which can eventually lead to dividend cuts and poor stock underperformance.
 
Conclusion
As we have seen, investors seeking to diversify their income streams might be well-served to consider investments in high-yielding dividend paying stocks. However, investors searching for income should take care when choosing among these stocks. Simply reaching for the stocks with the highest yields might not be the best approach. Ultra-high-yielding stocks have tended to underperform other above-average-yielding stocks and have had less favorable fundamentals: higher earnings volatility, higher leverage, and lower dividend growth rates.
 
Disclosure
The opinions contained herein are those of Longfellow Investment Management Co., LLC (LIM) at time of publication and may vary as market conditions change. They are based on information obtained by LIM from sources deemed to be accurate and reliable. However, accuracy is not guaranteed. It is in the sole discretion of the reader whether to rely upon the opinions contained herein. The information provided does not constitute investment advice, is not a recommendation, offer, or solicitation to buy or sell any securities, or to adopt any investment strategy and should not be relied upon as such. It does not take into account an individual investor’s particular investment objectives, strategies, tax status, or investment horizon. There is no guarantee that any forecasts contained herein will come to pass. Past performance is not an indication of future results. Investment involves the possible loss of principal. *The Case Study described above is for illustrative purposes only and is not currently held in any of the LIM Equity Strategies.