It is easy to look at a high-yielding income stock and assume that it is a wonderful bargain. But more often than not, a very high dividend yield should be interpreted as a warning sign, rather than an advertisement. Here is one high-yielder that I wouldn’t touch with a bargepole, and what I would add to my portfolio instead.
Since I last covered BT Group (LSE: BT.A), the stock is down almost 22%. In that article, I argued that the telecoms company was facing high growth costs, a mounting debt load and onerous pension obligations, all of which could threaten profitability and the security of the dividend. I also warned that while management’s plan to invest heavily in fibre optics may bear fruit in the long run, it would probably create a period of pain for shareholders in the short term. Looking at the company today, I see little to change my view on it.
The most recent trading update for Q1 threw up some concerning figures. Revenue was down around 1.4% year-on-year from £5.72bn to £5.63bn. Most notably, free cash flow fell sharply from £507m to £323m due to soaring capex as BT continued to spend aggressively on 5G technology.
With a P/E ratio of just 6.9, and a dividend yield of 9.7%, shares of BT could look tempting to some investors based on numbers alone. But there is a reason why large-capitalisation stocks can trade at such low multiples, and it’s because no one wants to touch them. Being a contrarian and buying low is an important part of being a value investor, but it is equally important to realise that markets are usually quite efficient and can price companies accurately when there is something wrong with them. Income investors should be wary of buying BT for its dividend as a cut could be coming, I believe.
By contrast, shares of Admiral Group (LSE: ADM) look well-priced. Sporting a 4.2% dividend yield and a P/E ratio of 16.8, this is a reasonably-valued stock. What I like about it, however, is how it has been able to entice customers from overseas, which I believe puts it in a comparatively better position than other insurers when it comes to Brexit uncertainty.
During its latest trading update, management of Admiral announced that group operating profit was up by 3.8% to £224m in the first half of 2019. More importantly, the motor insurer has a strong track record of returning capital to shareholders, which it built on when it announced that it would pay out 100% of its earnings in dividends in 2019.
Although international customers make up just a fifth of Admiral’s total revenues, growth of 21% for the segment is still highly impressive and makes me think that this could translate to the bottom line in the near future. And crucially, this is paired with a strong balance sheet that should give the company the ability to withstand unexpected shocks.
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Stepan Lavrouk owns no shares mentioned. The Motley Fool UK has recommended Admiral Group. 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.