Yield To Nobody

There's been some discussion recently on the Value Board about whether yield really is a worthwhile indicator for locating value shares. Not yield on its own, but as one of several filters that value players utilise such as p/e, p/tbv, p/cashflow, net cash/debt levels or whatever.

Once a short list of potential plays has been selected by some mechanical filter process like the above, it doesn't stop there. You then go non-mechanical, looking into the company to ascertain other facts about it such as the location of the business, the nature of the assets and so on depending on your personal approach to value.

As anyone who has followed my value trading ideas over the years will know, I have always found yield to be an important filter. My pyad approach uses four common criteria and the Y is for yield.

I see yield as doubly useful. Firstly, like most filters such as the commonly used p/e, it demonstrates relative value by enabling comparison with other shares to ascertain how cheap or dear a particular share is. This is what initial mechanical filtering for value is all about, locating shares which superficially at least appear to be cheap. The next step is to look at why the shares are cheap and whether that rating is justifiable or reflects potential value.

Secondly, yield tells you how much cash you can expect to receive while you wait for the share price to rise. (That's assuming that forecast dividends materialise.) Value investing requires great patience, often years, so you might as well have an income meanwhile.

This feature is unique to yield, other measures tell you something about a share or enable comparison with others but yield alone indicates a cash return. Furthermore, that cash return is part of the downside protection that is fundamental to the value style. The whole idea of value is to minimise the downside in share selection, long before you start to consider the upside potential of a share. A good yield helps to prop up a share price.

Put simply, a share yielding 5% appears to be more attractive than one on 4%. If they were otherwise identical value plays, the higher yielder offers better value. It is cheaper on yield comparisons and moreover the cash dividend return will be higher. It would make little sense for a value player to go for the lower yielder.

Critics of yield in value share searches argue that dividends are discretionary and that therefore they don't represent a particularly meaningful fact about a company. In comparison, other data is not discretionary and therefore says a lot more about the business. For example, p/e or p/tbv are derived from profit and loss accounts and balance sheets whose figures in turn are a function of the way the business has been run. The directors cannot decide every six months what those earnings and assets should be in the same way that they fix dividends.

This criticism is true, clearly dividends are discretionary whilst other figures are not. In practice though a share which has been listed for some time will have established a dividend pattern which the directors are generally loath to abandon. So although the level of payout is a regular human decision rather than a figure plucked from the accounts, this decision will be tempered by the dividend history of the company which constrains the decision to some extent.

Note that, in support of the dividends don't matter to value players view, although I see yield as a value indicator, the reverse is not true. That is, a nugatory or nil yield is not on its own an indicator of lack of value. A share which screams great value because it is on a low p/e, trades below tangible book, has net cash and most everything else you desire with the exception that it pays out little or no dividend is still a great value share. You won't receive any income whilst waiting but that may be quite acceptable if you believe it has great potential.

Summing up, I personally have always found yield to be a useful test for locating value shares to trade, as one of several filters. I do believe it is one indicator of relative value in addition to all the other filters, plus I like receiving an income whilst waiting, though not every value player will be too concerned about that. Very useful but not crucial in every case to the value player is perhaps the way to put it. What I can't accept is the extreme view that has been expressed that yield is useless as a value tool.

On occasion, yield can even be one of the strongest value indicators. This occurs with depressed big caps that will very rarely cut dividends. Take the big banks whose share prices are very low on a yield basis. Those substantial yields, way over the market average, make them very attractive value plays if you have the patience. Or do you think they will always trade on 6-8% or so yields?

No way.

Sooner or later either prices will rise or much less likely, divis will be cut. If payouts are not reduced, then whilst waiting you will receive an income higher than you can obtain in those banks' own deposits and very likely a good capital gain in the end. You'll need great patience and the ability to go through ups and downs though. But that's what value investing always requires.