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Income investing: is this 9.5% dividend-yield FTSE 250 stock too good to be true?

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Income investing has always been a key aim of mine. As we start 2021, I think it’s become even more important. The ability to generate passive income from investing in stocks that pay out regular dividends can help build up my savings. These savings can either be taken out, or simply reinvested back into the stocks. 

With the Bank of England base rate at just 0.1%, I can access higher returns from some FTSE 250 stocks. One that has caught my eye is Diversified Gas and Oil (LSE:DGOC). It currently has a dividend yield of 9.5%, considerably higher than peers and the UK base rate. Yet with a yield this high, I’m always slightly sceptical of it being sustainable, especially for long-term income investing.

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Why is the yield so high?

At a basic level, the nominal dividend paid per share has increased. This increases the overall dividend yield, as long as the share price remains fairly level. DGOC has increased the dividend a couple of times recently, on the back of strong financial results. For example, in Q3 of last year, adjusted earnings came in at $75m, up $64m from the same period last year. This led the company to raise the dividend by 7%, having already raised it 7% in Q2.

In an interview, the CEO was asked about the decision to raise dividends, and he answered that it was done “because we can, after generating a lot of cash flow”. From this angle, I think income investors like me should be able to buy the stock with confidence. The dividend cover stands at 1.4, which means that for every £1.40 of earnings, £1 is paid out as a dividend. This is a healthy ratio, and does make the current yield seem sustainable for income investing.

Income investing with commodity price risk

The numbers do stack up for DGOC for income investors, I feel. But the one element that I can’t really quantify is the risk attached to the oil and gas industry in general. It took me by surprise last year when oil fell into negative territory during April. Essentially this meant that people were paid to take oil off suppliers’ hands! 

DGOC was impacted by the volatile prices, but it said that due to good commodity hedging contracts, it hasn’t incurred as much of an impact as some. This hedging was clearly a good move, but doesn’t mean that it won’t be caught out in the future. Commodity prices have seen crashes fairly regularly. Even without focusing on it as an asset class, I can think back to the slump in 2008 and 2015. All it takes is another crash that DGOC wasn’t prepared for to really impact profitability.

If profitability is hampered, cash flow will be needed. Cutting the dividend is a logical place to start, especially given the dividend yield the firm currently has. So although I think income investors like myself could look at buying the stock, I’m still cautious. I’m certainly not going to be making a large investment, as a falling share price could easily wipe out any gains made from income.

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jonathansmith1 has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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