David Kuo talks to Todd Wenning, the lead adviser for Dividend Edge, our new investing service.
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David:
This is Money Talk, the weekly investing podcast from the Motley Fool. I am David Kuo, and today we're going to look at high yield shares with the help of our very own Motley Fool analyst, Todd Wenning. Welcome to Money Talk, Todd.
Todd:
Hi David.
David:
Hello. Now, before we get into the nitty gritty of high yield investing, can you give our listeners a quick overview of this particular investing strategy?
Todd:
Sure, so dividend investing is where you're buying shares that pay a dividend yield, rather than shares that just keep all of their earnings to themselves. So what these companies are doing is they're paying you a piece of their earnings in cash every year, which you can then use to keep and save, reinvest in the stock, or invest somewhere else. So it's giving you an option, and this flexibility is really what I like about the dividend investing strategy.
David:
So how does high yield differ from normal yield? I mean, most companies try and pay their shareholders something apart from those ones that don't make any profits, and those who want to keep it for themselves. But how do you differentiate a high yield from just a normal yielding share?
Todd:
Sure. So the two different types of dividend stocks that I look at, there's two themes.
First is what I call dividend growth, and this is sort of the companies that still have a lot of growth left in them – I'm thinking Tesco, Reckitt Benckiser, those types of companies, that pay around the FTSE 100, FTSE All-Share average in terms of yield, but they grow that yield or their dividend payout at about an 8 to 10% clip per year, I mean, they have that sort of earnings growth potential.
On the other hand, you also have high yield shares, which I consider stocks that yield over 50% the market average. So with the FTSE around 3% average, that's 4.5% average and higher, those are the Vodafones, National Grids. These companies pay a really high dividend, but their growth in the dividend isn't really going to be there. So you're buying those more for the current income than you're paying for the future growth in that income.
David:
But how do you know what they're going to be paying in the future? You know what they've paid in the past, but how can you get a handle on what they're going to be paying you next year and the year after?
Todd:
Well, what I look at are things like free cashflow cover, and by free cashflow I mean the cash that's left over in the business for shareholders after the company's already made all of their investments to continue growing the company. If there's plenty of cash left over after they've done that to cover the payout, that means, in my mind, that there's enough cover for that dividend to continue. In terms of what they may pay next year, it depends on the company. Some companies will come out and say, we intend to grow our dividend at the same rate as our earnings per share, or they have a set target – 8%, 6% per year over the next few years.
So it really depends on the company, but we also look at how well this business is doing, so we look at the actual business. I look at things like return on equity. What type of investments is this company making to return the value to shareholders? If its return on equity is over 15%, I can say that's a very good return, and I think that the company has the investment still available to it to continue to grow.
David:
Now, you make high yield investing sound relatively interesting, but I've spoken to investors who say, well high yield investing is a poor relation to proper investing, because it doesn't carry the same kind of cachet as go go growth, or the same level of satisfaction as unearthing undervalued shares. Do you go along with that argument?
Todd:
Well, I think that high yield investing is still very interesting, because it requires a sort of behavioural discipline, whereas some of the more go go growth type investing doesn't. I think that so many investors today are so focused on the short term. You know, over the past ten years, we've had a real volatile market, both here in the UK and in the States. So back in 1999, we had everyone thinking long term was the way to go, because the market had been going up for the past 15 years.
But now, with the market so volatile, short term is where everyone wants to be, when in actually that's when I want to be a long-term investor, because I think that there is a benefit in long term investing. So what I do is, with the dividend investing, what makes it interesting is that you complement other shares with each other, so you build a portfolio rather than just buying one and sort of sitting back and letting that thing grow. You put them all together and that makes an interesting dynamic as a portfolio.
David:
Now, I spoke to a professional investor probably a few weeks back on Money Talk podcast, and he was telling me, he said, "Yeah – dividends are great, they just kind of pay my trading cost", he said, "I'm really after the capital growth." What would you say to an investor like that who really shuns dividend investing?
Todd:
Well, I think everyone has their own personal style of investing, it is certainly fine for people to do that. Now, if you look back throughout history, however, dividends have generated multiple times the amount of return to investors than capital gains have, because capital gains are very temporary at some times – sometimes you're up, sometimes you're down, but when you have a dividend, you're getting that real return every year.
So as you do that, and you can reinvest in the company, and if the company continues to grow, you add more shares as you're going, which increases your compounding return, which over time makes your return perhaps even better than someone who just put it in a stock that didn't pay any dividend, and was banking on capital returns.
David:
I have to say, I have a soft spot for high yield investing, because I love nothing more than seeing that dividend cheque hit my bank account, and I just say, yes! – I've actually sort of made something. But apart from me and my personal preferences, who are the people who should be considering high yield investing?
Todd:
Well, I think it's appropriate for just about any age, David. I think it really depends on ... given the flexibility that dividends give you, the ability to reinvest and buy more shares, or to just simply save it, that gives you a lot of options. So if you're an older investor and you're looking to collect that income and use it to buy your groceries, pay your rent, whatever, you can do that.
On the other hand, if you're a young investor, if you're in your twenties, your thirties, you can take that dividend, reinvest, buy more shares, and then when you get to retirement you can have a larger pie to draw all your income from.
David:
So are you almost saying that high yield investing is an alternative to buying an annuity when you retire?
Todd:
Well, I don't think the two need to be mutually exclusive. I mean, I think that you can use us as a part of your portfolio. Everyone has a different retirement plan going in whenever they need to draw the income, so this can be a part of it. I don't know if I would consider it to be the only option you use, because I think there is some value in the annuity, some sort of guaranteed return, is good for peace of mind, and there's some benefits for that, whereas with dividend investing, there are some great benefits for that as well. For example, you can continue to hold it, there's no guaranteed period, so there are some benefits to both. So I don't think they need to be mutually exclusive.
David:
Now, you're almost making it sound as though high yield investing is almost risk-free – is it risk-free?
Todd:
Not at all. No, I mean, let's not forget we're dealing with shares here, this is the share market. Dividends, as we learned over the past two years where dividends had a really tough go at it, there were a ton of dividend cuts, a ton of dividend suspensions, in various markets around the world, and it just reminded us that dividends are a privilege and not a right.
So the board of directors at each company has to approve the dividend every time it wants to pay, and when times are tight, and the company can't afford the dividend, they can cut it just as easy to save cash. That might be good for the business long term, it may not be good for you, who are looking for the income right now.
David:
So what exactly did we learn from 2008/2009, when we saw lots of companies cutting their dividends, and probably more recently a company like BP, which always had a very reliable dividend yield cutting its dividend? What did we learn from those experiences?
Todd:
Well, we learned quite a lot. I think anybody that was investing in a high yield in a portfolio during that period certainly learned a lot, whether the hard way or the easy way. I certainly did, and that really solidified some of my strategies going into the new service. One thing I learned was that, to be really afraid of high yield for high yield's sake, so going out, and there are times where Lloyds was yielding 10%, the Royal Bank of Scotland was yielding a lot, but those were the times that we should have been afraid. So we need to make sure that we're not just investing for the yield, that we're making sure that those yields are sustainable.
A good strategy will continue to have the current income level at least ten years down the road, so we need to be careful that we're buying these shares at good prices and that their dividends are sustainable, that there's plenty of free cashflow to cover them, and that their companies have good balance sheets to cover it too.
David:
But surely, I mean often times, these companies that you mentioned, like Lloyds Banking Group, and probably more recently BP, they had so much cash, Todd, that they didn't know what to do with it. Now, if they were going to keep it for themselves, a lot of investors would say, hey, you know, stop – because we're investing in you so that you can actually give us some of that cash, and similarly with tobacco companies – they don't really need to grow their business any more, do they? So if the yield is excessively high, surely we should just take that and say, thank you very much?
Todd:
I think that there is some value to high yield in itself, but I think that we need to be careful of why these companies are paying such high dividends. If they're paying such high dividends, that means one of two things. If the yield is high, it means that the stock price may be down, and that the market has concerns about the company long term. The other reason is that, if the company is paying an enormous yield, it means that it's not funding the projects to invest in that, or worth keeping the money rather than paying it out to shareholders. So we need to be cognisant of what they're doing with the money, and why they're doing it.
David:
So you're almost suggesting, in some ways, that we should have a basket of shares, rather than to put all our eggs into one basket, or rather just to sort of bank on one or two shares that are going to do well. So how many shares would you consider to be sensible for a dividend basket?
Todd:
I think as many as you feel comfortable owning, and have enough time to continue to cover, and also have proper diversification. So I wouldn't go out and buy five consumer staples of companies, even if you really like all of them, because things can happen – a consumer recession could come along, like we had, and really put a pinch on those companies.
So I think, as long as you're diversified into a various number of sectors, and you feel comfortable with the companies that you're buying, and you have time to cover them for a number of years, then that's the size of portfolio you want. So if I had to give a number, I would say, I would be comfortable with around 15 to 20.
David:
So 15 or 20 shares should be adequate, provided you are not 15 and 20 shares in the banking sector, or 15 and 20 shares in the mining sector?
Todd:
Right, correct.
David:
So how does one go about maximising yield, or shouldn't really we be trying to maximise yield in some ways?
Todd:
I think that there needs to be a balance between making sure that you have a group of stocks that have plenty of dividend cover; in other words, a group of maybe a dividend growth stock. So maybe you're not getting a great yield out of all of them, but overall you're pairing that with some very high yielding stocks that do have the cashflow, but may not be growing as much. So you have some good dividend growth stocks and some good high yield stocks. So together, when you put them together, they have a yield that's 50%, 25% higher than the FTSE 100 average.
David:
Now, I have to let you in on a little secret, Todd, because I have a portfolio of high yielding shares, and I use a spreadsheet, and I try and maximise the number of shares in each of the companies that I have in order to try and maximise the yield. I mean, Excel has some wonderful scenarios where you can sort of say, what if I did this and what if I did that? Would you recommend that as a strategy for someone, or do you think it just isn't worthwhile doing?
Todd:
Again, it all depends on selectivity. If you can go and you can buy five high yielding companies, for example, that you're very comfortable with in terms of the sustainability of the dividend and the future growth of the dividend, then by all means go and do it. But I also don't recommend going to a list of FTSE 100 or FTSE All-Share, and sorting by the highest yield and just picking the top ten, because you have to look at why those companies again, why they're paying such high dividends relative to the market. There's obviously something going on that is making them pay that difference from the market.
David:
So how important is it to review the high yield portfolio? You're almost suggesting that, if I were to buy a share at the moment that was a reasonably high yield, and it suddenly became very high yield, I should be considering taking that out of my portfolio then?
Todd:
Well, I don't think so. I think that, if the yield does shoot up, it means that the stock price went down, or the company paid a higher dividend, in which case the market may bid it up back to where it was before, bid up the stock price to where it was before. So again, we have to look at why these companies are paying dividends, what's going on, and how we can work with it.
David:
Now the thing is, I know you are going to be coming over to the UK very shortly to be starting this high yield service for us?
Todd:
Yep.
David:
Will you be telling our subscribers how to actually go about finding and identifying these high yield shares?
Todd:
Absolutely – that's one of my main goals with this new service. I want to make sure that people can not only follow along with what we're doing at the new service, but also learn to do it themselves. So I'll give them tools and show them how to find the companies that they can use for their own portfolios separate from what we're doing at Dividend Edge.
David:
And how long have you actually been doing this yourself, unearthing high yielding shares?
Todd:
I've been doing it since just out of college. I worked with some very high net worth investors, I helped manage their portfolios. That's what really changed me in terms of my investing strategy. Originally I came out of college wanting to be a Wall Street trader – in and out really quickly and make a lot of money, retire to some beautiful island before my time, and I sat down and I looked over these portfolios of these high net worth investors, so we're talking tens of millions, hundreds of millions of dollars.
What was common in all of their accounts was, they weren't investing in these start up, biotechnology companies, they were invested in some of the greatest brands in America at the time – Coca-Cola, Procter & Gamble, and they've held them for years and years and years, and they've allowed their dividends to reinvest and compound, and their returns are just absolutely incredible. Today they're living off their dividend income, and very comfortably, I might add. So that really showed me that if you can find great companies, and buy them when they're undervalued, and hold them, and collect their dividends over time, your compounding returns will accelerate and give you good returns.
David:
Now, the thing is, I want to go back to something that you said a few minutes ago, and that was, when you are building this basket of high yielding shares, are you suggesting it isn't a good idea just to stick to UK shares, but to actually look outside of the UK, and into other areas as well?
Todd:
It depends – again, I think that for most investors, there's a good reason to look overseas, to fully diversify your high yield portfolio. For example, one of the things that I've seen as I've looked over the FTSE All-Share is that there are very few blue chip technology companies in the UK that pay much of a dividend, or at least one that I would like for my own portfolio.
So I've looked at some of the United States alternatives like Intel and Microsoft, and while these companies aren't paying enormous dividends over 4%, Intel is at 3.2% and I believe Microsoft's at about 2.6, you are getting that diversification, you're getting a good yield, and these companies have plenty of free cashflow cover for their dividend, and continue to grow it for many years. So if you're looking to diversify, I think that going to the United States, or perhaps going to Europe, is a way to do it, if you can't find the best shares in the UK.
David:
Because I was going to say, there is a cultural difference between here in the UK and over in America.
Todd:
That's true.
David:
We tend to be slightly more focused on dividends, whereas you in America prefer the capital growth. So how are we going to actually justify putting something like Microsoft into a basket of high yielding shares when people will turn their noses up at something paying just 2%?
Todd:
Actually, I was just in San Francisco this past week meeting with Motley Fool members, and we met with Intel. Intel was very committed to its dividend. I chatted with the investor relations representative that was there, and he was saying that their dividend growth is a key strategy going forward. They really want to grow it at a much higher rate. Bill Miller, who's a great fund manager here in the United States, said that Intel should be paying about 70% of its earnings out in dividends, which would put its dividend at about 6%.
So there is some upward momentum that's going on in these blue chip tech firms in the United States. They're sort of transitioning from their high growth period, which was 1995 to 2005, around that period, and now they're transitioning into more mature companies, and I think that spells a good opportunity for longer term investors.
David:
Now the thing is, I mentioned that there were some cultural differences between America and the UK in terms of dividends. There are also differences between terminologies that we have in the UK. So before you actually come to Britain, Todd, I'd like to test you on how well you understand English terminology.
Todd:
I'm working on it.
David:
Are you working on it? Now, I'm going to give you a list of American phrases or American terminologies, and I want you to give me the English equivalent, OK?
Todd:
OK, I'll give it a shot.
David:
OK, let's have a go at this. You say drugstore, we say ...?
Todd:
Chemist.
David:
Really? – OK.
Todd:
Is that right?
David:
Well, I'm not telling you yet! You say elevator, we say ...?
Todd:
I think I'm pretty sure on this one, it's lift?
David:
It is a lift. You say sweater, we say ...?
Todd:
Jumper?
David:
We do say jumper. You say pants, we say ...?
Todd:
Trousers.
David:
We do say trousers, right. You say panty-hose, we say ...?
Todd:
Well, I don't wear them, but tights.
David:
It is tights. Now, you say sweatpants, and we say ...?
Todd:
Er – joggers, is that right?
David:
I'll give you joggers – it's actually tracksuit bottoms. Right, I hope I don't offend anybody by saying this last one – you say fanny bag, we say ...?
Todd:
I never liked that word, that's just for the record. Just in general, a bum-bag.
David:
It is a bum-bag. You have scored 7 out of 7.
Todd:
Wow!
David:
I think you are ready for the UK now, Todd!
Todd:
All right! – looking forward to it.
David:
Well, it only remains for me to give you the quote of the day, and today's quote of the day comes from a man called Anon, Anon has made another appearance on the podcast. He says: "If you aim at nothing, you hit it every time", and I think everybody who invests needs a strategy, don't they?
Todd:
They do, indeed.
David:
And a high yield strategy, as far as I'm concerned, is as good a strategy as ... well, it's probably a better strategy than most others, for people of my age. So thank you very much for joining me today, Todd.
Todd:
Thank you, David.
David:
Now, the next time we speak, I hope it's going to be face-to-face rather than down the line.
Todd:
I hope so too.
David:
This has been Money Talk, my name has been David Kuo, and my guest has been Todd Wenning, analyst at the Motley Fool. If you have a comment about today's show, please post it on the Money Talk discussion board, which you can find at fool.co.uk/podcast. If you have a suggestion for future shows, please email me at moneytalk@fool.co.uk. Until next week, everyone have a great week.
> Find out more out Dividend Edge, our new investment service.
