Ultra-large dividend yields unsettle me. Any yield above 7% starts to look more like a warning than an opportunity, at least to me.
In many cases, such yields arise because a firm is out of favour with investors, but you’ve got to ask why. Generally, I think the stock market represents an amalgamation of the views of all the individual investors participating in it, as such, the market is much smarter than we often give it credit for.
Valuations ‘correct’ in several different ways
If we pounce on a stock that’s assigning its underlying company a low valuation, we usually do so because we think the market will realise its ‘mistake’ and mark the valuation up, taking the share price with it. If it doesn’t, we’ll be happy to collect the income from that big yield. But very often the valuation anomaly corrects itself in a different way – the dividend gets slashed and earnings fall!
Right now, we’ve got two well-known companies sitting with ‘ridiculously’ low valuations and gargantuan dividend yields in Royal Mail (LSE: RMG) and Standard Life Aberdeen (LSE: SLA). But I wouldn’t invest in either of them right now.
I don’t think Royal Mail’s low-margin parcel and letter delivery business is going anywhere and the firm strikes me as being in a struggle to survive. The letter business is in structural decline, but the firm must keep running it because of its obligations under the Postal Services Act 2011. Ofcom keeps a close eye on Royal Mail to make sure it fulfils its duties under the act. Meanwhile, the parcel delivery business faces ever-increasing competition, and that’s bad for ongoing profit margins.
Royal Mail has a record of generally declining earnings. City analysts forecast that in 2019 and 2020, earnings will be so low that they are set to only just cover the projected dividend payments. I see the dividend as being under threat and it’s hard for me to imagine business turning up in the future.
Gearing up on volatility
Standard Life Aberdeen is an asset manager dealing in stock market investments. You probably don’t need me to tell you that investing in the stock market has been difficult lately. But stocks like this tend to exaggerate the swings in the general market. In other words, we often say they tend to be “geared to the market.” Generally, operations are cyclical, so in an economic downturn, Standard Life Aberdeen’s shares will likely fall.
Assets Under Management and Administration (AUMA) have been declining. Investors have been pulling their money out of the firm’s funds and it will take some good fund performance figures to attract money back in, I reckon. But I’m not holding my breath for that in today’s markets. Needless to say, earnings are sliding and City analysts expect more of that this year and next. So much so that earnings are not set to fully cover the projected dividend payments. I think the cyclical risks are too great with this company and could easily imagine a dividend cut and share-price plunge down the line.
Instead of these two, I’d rather invest in an FTSE 100 tracker fund that automatically reinvests dividends. Over the long haul, I reckon my returns from a tracker will likely beat anything Standard Life Aberdeen or Royal Mail will probably deliver.
It's easy to make a million by using a simple strategy such as tracking the FTSE 100 and letting your money work for you. Unfortunately, most investors 'over-trade' and, as a result, their returns suffer significantly...
To help you avoid this key mistake, the Motley Fool has put together this free report entitled "The Worst Mistakes Investors Make". These mistakes can cost you thousands over your investing career but the best part is, this report is free to download.
Click here to get your copy today.
Kevin Godbold has no position in any of the shares mentioned. The Motley Fool UK has recommended Standard Life Aberdeen. 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.